The Second Key to Forex System Development: Simple Entries and Complex Exits
Education - AxiTrader Team | 06 May 2014
The views outlined by the author in this blog post are their own and do not reflect the views of AxiTrader. Forex trading is risky and is not suited to everybody.
If you did not read the First Key to Forex System Development, you can access it here.
The questions I get asked the most about Forex trading are:
- When to enter
- Where to place your stop
- When to exit.
They are some of the most important questions you’ll answer in your Forex trading plan. Together they form the decision-making engine of your Forex trading system.
But before we get started, the first step is to get your head right.
You need to get the correct perspective about where these three components fit into your trading plan.
While entries and particularly exits are critical to your system’s performance, we have not yet touched on your trading psychology, your position-sizing model, how to trade mistake-free, or the power of objectives.
You can have the best entries and exits in the world and still lose if you don’t integrate ALL these factors.
My belief is that around 15% of your energy should be spent on this area, with the majority of that time on the exit part of the equation.
You have spotted it, right?
I started this article by talking about the importance of entries and exits and now I am saying they are not to be treated with such reverence.
The reason why this question is important to you is because if you answer it wrongly and spend too much of your focus searching for the Holy Grail entry, then you will experience a major time-suck… or worse, you will end up with a half-baked system that loses you not just time but money.
The true role of entries and exits
Each trade is like a draw from a lucky dip or a spin on the wheel of fortune.
The better your entries and exits, the more winners in the draw, and the easier it will be for your Forex trading system to meet your objectives.
Your goal for your entries and exits is to add as many winning tickets into the draw as possible – or to add in tickets that when you do pull them ensure you win the jackpot.
When you internalise this concept, you can start to see how entries and exits fit into the bigger picture of your Forex trading system. They lose their mystical appeal.
You don’t need to have a system that is perfect, just one that produces enough winners over time, with which you can bet enough on each trade to:
- Not experience a drawdown over 25% (it’s hard to recover from a drawdown this large without being extra risky);
- Achieve your objectives over time.
Are high probability entries better?
Building a trading system is a little like building a house.
When you construct a house you decide how many rooms it will have, the layout, how many floors and so on. These decisions are based on your needs (objectives), budget (trading capital) and what suits your personality (psychology).
Similarly, when you develop entry and exit strategies for a Forex trading system, you get to choose things like its targeted risk/reward ratio, win rate and the number of trades over a time period (i.e. you want to place 5 trades a week). Your choices here will be a reflection of your needs, budget and goals.
Take a look at these three examples of Forex trading systems.
System 1 generates 10 trades a month with a 90% win rate. Winning trades make $100 and losing trades lose $1000.
System 2 generates 80 trades a month with a 60% win rate. Winning trades make $60 and losing trades lose $50.
System 3 generates 10 trades a month with a 15% win rate. Winning trades make $1800 and losing trades lose $150.
Before you read on, which Forex trading system would you prefer?
Note it down along with the reasons why it is your system of choice.
Here are the results for a month’s trading for each system in dollars:
- System 1 with a 90% win rate had a $100 loss
- System 2 with a 60% win rate had a $1280 profit
- System 3 with a 15% win rate had a $1425 profit.
What do you notice here?
The system that made the most profit had the lowest winning rate – and the system that lost money had the greatest win rate.
Now would you still choose the same trading system you chose above?
When you are developing your entry and exit, the one with the most wins is not always the best. Be careful not to fall into this trap.
(As a side note, it is possible to have a system that has a high win ratio and larger losses than profits. It’s just tough if you experience four or five losses in a row, so make sure you position size accordingly.)
A risk/reward ratio filter for your trades
Entries and exits should never exist independent of each other. Their relationship can be expressed though the risk/reward ratio.
Your risk/reward ratio is how much you can potentially profit on the trade compared to your initial risk.
You determine this by working out your initial stop and profit objective.
For example, if you are risking $1 to make $3 you would have a risk/reward of 3:1, like you can see on the below USD/CAD chart.
It can be beneficial to have a rule in your trading plan that you only want to place trades that have a certain risk/reward ration.
You may only take trades that have a risk/reward ratio of 3:1 on longer-term positions, or of 2:1 on shorter-term positions. This would mean you avoid placing the following trade (or look for a profit objective further out).
Simple entry techniques work
Simple entry techniques work.
They allow you to focus managing your trade after you enter rather than on interpreting a jumble of indicators to work out the best time to buy.
A good entry has two main criteria.
A set-up is a condition you watch for prior to entering your position.
This could be:
- The market type
- A upcoming news event
- The market’s reaction to a news event
- A chart pattern
- A breakout
- Fibonacci levels
- Market fundamentals
- The view of an expert
- A combination of the above.
Once your set-up occurs, you then move into stalking mode.
Finally we get to the entry.
Now you become the hunter or huntress, spear in hand, pursuing a high-quality entry with dogged determination. You are face-to-face with the markets, unwavering while you wait for the perfect moment to strike.
When the time comes you execute with aplomb. Your supreme skill netting your target with ease.
Typically you will look to drop to a lower time frame from your set-up to improve the risk/reward ratio.
You could then employ a technical analysis technique such as candlestick analysis for the actual entry.
For example, on the earlier USD/CAD trade, if you went to a lower time frame you would have seen a strong reversal pattern (a spinning top followed by the bullish engulfing candle) that would have allowed you to get in earlier and improve the risk/reward ratio.
Complex exits are essential to a fully-fledged Forex trading system
The term “complex exits” is somewhat misleading. Each exit is quite simple on its own. The complexity comes with the variety of exits that are required to:
- Trade what is in front of you
- Achieve your objectives.
It is how you react to what happens after you enter the trade that matters.
Here is a list of some exits you can consider for your trading system.
Your initial stop defines your risk on the trade. While there are ways to work out your risk/reward on a trade without an initial stop, it does not come recommended for the uninitiated.
Break-even stops are a powerful psychological tool. They allow you to get into a “risk-free” trade (excluding slippage).
Consider moving your stop to break-even after a certain amount of profit or a weak mid-range reversal signal.
A profit target is an order you place in the market to close your position once it hits a certain price. These are useful in sideways markets, but some experts suggest that they work well in trends too.
A profit objective is different to a profit target. A profit objective is a goal for your trade. When you understand your system, you will know how much profit a trade is capable of making. You can then manage the trade is a way that seeks to maximise profits.
All sounds a bit mystical?
It is really about letting profits run or altering profit targets based on what the market is doing in front of you.
Trailing stop (price or indicator)
A trailing stop (surprise, surprise) trails the current market price. There could be a whole article on trailing stops there are so many, suffice to say they can be based on a set price (say 50 pips) behind the market or they can be based on an indicator such as a moving average.
If you like moving averages, try displaced moving averages. There is something to them, but I don’t use them myself these days.
I will cover two more types of trailing stop below because they are particularly important.
Rapid market trailing stop
Sometimes the market defies gravity and launches into a rapid move, only to come crashing back to ground.
If you are in a trade that takes off like this, then you can adjust your trailing stop to avoid giving back your gains. Perhaps you go to a lower time frame or be prepared to only give back one or two times your risk.
You can see on this one-hour chart on the USD/JPY how speedy moves can quickly reverse.
Support and resistance trailing stop
Support and resistance are difficult prices for the market to move through. They also form a platform for a further extension of the price.
With a support and resistance trailing stop, you logically trail your stop behind the market in order to protect profits.
Tip: Be wary of short, sharp penetrations of resistance levels, and be ready to get back in.
You can exit based on price action. For example, you might see a candlestick reversal pattern that indicates the trend is coming to an end.
Large daily move
Depending on your trading time frame, if there is a large daily move of say 300 pips, you could look to sell as the market has most likely overshot.
You can exit a position based on market fundamentals and news. For example, you might close out of your short-term positions prior to a major news announcement, or exit a position on negative news.
You may exit after a specific period of time in a trade or on Friday before the market closes for the weekend.
The cross rates
Savvy traders often monitor the cross rates to get an indication of the direction of the currency pairs they are trading. If the price action on the cross rates is signalling weakness, then it might be time to exit your trade.
If you follow a particular expert, you may choose to close your position if they suggest the market is about to turn.
With a risk/reward stop, you adjust your stop-loss to maintain a minimum risk/reward of at 1:1 at all times. This powerful approach helps you to maintain your profits if your trade gets close to your profit target, does not touch it, and reverses.
If you have a specific account-based goal such as 25% for the month, then you may close all positions in your account once this target is achieved.
By scaling out, you exit portions of your position, based on different criteria. For example, you might take a small amount off when the market first make some available, some more at a pre-planned target, and finally leave some on a trailing stop to capture the big wins.
Complex exits enable you to trade the market in front of you
By having a variety of exit strategies in your toolbox, you can effectively manage your position based on what happens in the market after you enter.
You can intently watch the market and adapt to its movements in order to generate the best possible result for you trade.
Be in the moment with it.
As a trader you can only plan and then be present. Once you execute the trade you are simply experiencing, not creating. Your exit decision should be based on what the market is doing right now, not dependent on a perfect recreation of a historical pattern that conforms to your back-tested indicators.
It’s not difficult.
If you enter simply and apply the right exit to the right scenario, then you will have uncovered the second key to Forex system development.
And as always, I encourage you to get out your trading plan or trading journal and integrate this lesson into your Forex trading for maximum effect. Pick one or two next exits from the list you want to add today, and then over time you can come back for more.
If you missed out on the First Key to Forex System Development you can click on the link to view:
The First Key to Forex System Development: Market Types
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