Exiting trades successfully can be the hardest thing you do - here's a road map to success

Trading is simple, but not easy.

Simple because good traders follow a set of rules which establish their entry, exits, position size, and money management protocols.

Not easy, because establishing the set of these rules - this process - which suits any individual trader takes time, work, and practice.

All with no guarantee of success.

This article is dedicated to those traders still struggling with one of the most important areas of trade management.

The exit.  

Exiting a trade is easy when you are wrong. 

It may sound trite to say it but exiting a trade is easiest when you are wrong. That's because the stop loss takes care of that for you.

Now, of course, this begs the question of where a trader sets their stop, and how they set that stop. Let me put that to one side - for another article - and assume that traders do the prudent thing and protect their position, themselves, and their capital with an appropriate stop.

But of course the idea of a stop loss for many traders is just that. It's an idea.

I remember that in my first trade I doubled down when the market moved against me. I'd bought 25 lots of the 90 day bank bill future contract on the Sydney Futures Exchange became 50 when prices fell and my boss - the head trader - asked me what I thought.

The much younger me spoke words the almost 50 year old version would never say. 

"I reckon I'm right," I said. 

"Buy some more then," the Boss said. 

So I did. And the loss on 25 lots eventually became a profit on 50 as I got lucky and the market moved higher once again. We went to the pub to celebrate.

Danger Will Robinson!

I'd just been taught that I was right and the market was wrong. I'd just been set up to trade at $625 a point that became $1,250 a point without a stop. Without an exit plan when I'm wrong. 

First lesson. The market is the market. The arrogance of "I reckon I'm right" should never pass one's lips. 

These days I trust my process and my system. A trade is but one in a series of thousands of trades. And if it doesn't work out the stop loss will look after the exit and the - known - amount of capital I am prepared to risk on any given trade.

So with a stop loss exiting on losing trades is easy.

But exiting a trade at other times  CAN BE MORE COMPLEX.

Indeed from my experience the hardest thing to do sometimes is to know when to exit a profitable trade - some say a winning trade. But this is not a game and I detest that phrasing.

First a bit of background.

The behavioural psychologists have shown that we humans are not the rational utility maximisers that the faux-scientific branch of economics and finance that has develop over the past 50 year or so would have us believe. We are, after all, human with all that comes with it. 

In a trading sense the best way to explain that is traders often hang on to their losing trades in the hope that they'll come back into the black. It also means that traders don't hold onto their winners long enough. They are scared the trade in the black will reverse and run into the red.

Put simply too many traders lets their losses run too far and cut their profits too soon. 

It's a human trait. We are all prone to it. And the result I often saw in myself in the early days, and in traders I've worked with over the decades, is that profitable trades can be more stressful than losers. 

The stop will take care of that. 

So here are three ways that I think can help traders manage their trades a little better when they are running in the black.

Trailing stop

The trailing stop is probably the most emotionally successful way for a trader to manage a profitable trade. That's because in the same way that the stop protects your initial positions at the risk parameters a traders is happy to accept, so a trailing stop can convert those risk parameters into a real time position protection as the market moves. 

And of course, a trailing stop is exactly what it says on the box. It is a stop loss which trails the market moving higher on a long position, or lower on a short position, as the market price of the asset being traded moved.

Say you bought AUDUSD with an initial stop of 50 points and a trailing stop of 50 points. That would mean that as the price moves higher the stop will "trail", move, higher with it. For example any AUDUSD longs with a trailing 50 point long during last week's rally to a high of 0.7712 would now have the stop at 0.7662. A fall back below that level would see the long AUDUSD trade exited.  

Traders can also use other indicators as trailing stop loss levels.

In the past, when I was a portfolio manager, I have used the Parabolic SAR indicator. The original Turtle Trend following system used a look back function for the lowest low or highest high (depending on whether the position was long or short) for a certain period of days as the trailing stop. 

There are many ways to set the trailing stop. But as a behavioural finance and economics guy, one who believes we shouldn't pretend we don't have emotions but use tools to keep them in check, I strongly believe trailing stops are an important part of any traders tool-kit. 

Price Target

Trend followers would be aghast at the notion of setting a price target. They follow the market and then let their trailing stop take care of the position for them. 

But in my own trading I find price targets are an essential part of trade management. 

Essentially I have two main approaches to trading.

One is a simple Fibonacci style approach which looks for support and resistance at certain ratios. My favoured approach is to look for moves back to the 61.8% level of a move - the 38.2% retracement - once a top, or bottom, has been set. Indeed, my first trading system was a derivation of this. Once I saw that retracement if price then went back and took out the high, or low, immediately before the retracement then I would look for a move to the 138.2% level of the previous move. That was my profit target. 

The second approach, I use in my daily trading now, is that my systemised approach enters at full risk limit once a signal has been generated. The initial target is then my fast moving average. At this point I reduce my position by 50%, with the next target usually either the slow moving average or the 38.2% retracement level of the move price is reacting from. At this point the position is reduced a further 25%. 

The rest of the move is looked after by the trailing stop or a reversal signal. 

There are off course many other ways to generate price targets for exit. Kathy Lien in her Double Bollinger Band strategy likes to use the first Bollinger band as an initial target to reduce risk. 

The reason for the trade disappears

Your entry signal for a trade will be based on the set of criteria a trader has established based on the parameters they believe give them their edge. 

So it's reasonable to also assume that when market price action takes away that criteria - the rationale - for the trade that an exit can be effected. 

In my own trading I use trend lines, and levels, as my secondary and discretionary overlay of my trading a system. A long that fails at an important trend line, or a short that does likewise, are usually closed out. Likewise a short that breaks an important trend line will be instantly exited as a sign price is moving higher.

Naturally my trailing stop loss will take care of a reversal. But if the break is off a significant level it is usual for me to pre-empt the stop rather than wait and give back the extra bit of profit that the distance between the trend break and the stop represents. 

What's important about this approach, at least for me, is that because it is prone to subjectivity I have to be systematic about it. Hence I don't close out a position in this manner because it "feels" wrong. I close it out because the price action has told me that something has changed, the reason for the trade has disappeared 

Conclusion

Stops take care of your exits on a losing trade. But exiting profitable trades is often much harder. 

It's important that traders establish a solid protocol to exit profitable trades so they can defeat the psychological bias human traders have to let their losses run and cut their profits short. 

There are many ways to do this beyond the simple explanations I have outlined above. But I believe it has been an essential part of my trading that I've established my own guidelines on how to do this.  

Have a great day's trading.

Greg McKenna 

Chief Market Strategist

gregmckenna.com.au 

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