In many ways, a good exit is more critical and difficult to achieve than a good entry.
The big difference is that while waiting for a good opportunity to enter a trade, there
is no market risk. If one opportunity to enter is missed, another will always come
along-and a good, active trading model should provide many such opportunities.
When a trade is entered, however, exposure to market risk occurs simultaneously.
Failing to exit at an appropriate moment can cost dearly and even lead to the dreaded
margin call! We actually know someone who made a quick, small fortune trading,
only to lose it all (and then some) because the exit strategy failed to include a
good money management stop!
There am two goals that a good exit strategy attempts to achieve. The first and
most important goal is to strictly control losses. The exit strategy must dictate how
and when to get out of a trade that has gone wrong so that a significant erosion of
trading capital can be prevented. This goal is often referred to as money management
and is frequently implemented using stop-loss orders (money management
stops). The second goal of a good exit strategy is to ride a profitable trade to full
maturity. The exit strategy should determine not only when to get out with a loss,
but also when and where to get out with a profit. It is generally not desirable to
exit a trade prematurely, taking only a small profit out of the market. If a trade is
going favorably, it should be ridden as long as possible and for as much profit as
reasonably possible. This is especially important if the system does not allow multiple
reentries into persistent trends. “The trend is your friend,” and if a strong
trend to can be ridden to maturity, the substantial profits that will result can more
than compensate for many small losses. The protit-taking exit is often implemented
with trailing stops. profit targets, and time- or volatility-triggered market
orders. A complete exit strategy makes coordinated use of a variety of exit types
to achieve the goals of effective money management and profit taking.
Exits employed in an exit strategy:
There are a wide variety of exit types to choose from when developing an exit
strategy. In the standard exit strategy, only three kinds of exits were used in a simple,
constant manner. A fixed money management exit was implemented using a
stop order: If the market moved against the trade more than a specified amount.
the position would be stopped out with a limited loss. A p&It rarget exit was
implemented using a limit order: As soon as the market moved a specified amount
in favor of the trade, the limit would be hit and an exit would occur with a known
profit. The time-based exir was such that, regardless of whether the trade was profitable,
if it lasted more than a specified number of bars or days, it was closed out
with an at-the-market order.
There are a number of other exit types not used in tbe standard exit strategy:
trailing exits, critical threshold exits, volatility exits, and signal exits. A trailing
exit, usually implemented with a stop order and, therefore, often called a trailing
“top, may be employed when the market is moving in favor of the trade. This
stop is moved up, or down, along with the market to lock in some of the paper
profits in the event that the market changes direction. If the market turns against
the trade, the trailing stop is hit and the trade is closed out with a proportion of
the profit intact. A critical threshold exit terminates the trade when the market
approaches or crosses a theoretical barrier (e.g., a trendline, a support or resistance
level, a Fibonacci retracement, or a Gann line), beyond which a change in
the interpretation of current market action is required. Critical threshold exits
may be implemented using stop or limit orders depending on whether the trade
is long or short and whether current prices are above or below the barrier level.
If market volatility or risk suddenly increases (e.g., as in the case of a “blow-off
top), it may be wise to close out a position on a volatility exit. Finally, a signal
exit is simply based on an expected reversal of market direction: If a long position
is closed out because a system now gives a signal to go short, or because an
indicator suggests a turning point is imminent, a signal exit has been taken.
Many exits based on pattern recognition are signal exits.