Knowing When To Exit A Trade
· To explore the often-overlooked element of trading — “Knowing When To Exit A Trade”.
· To identify the pitfalls of exiting a trade and remedial strategies to reduce these risks.
· To conclude on effective approaches to “Knowing When To Exit A Trade”.
To profit in financial markets requires a skill set that ultimately garnishes the conclusion of exiting in a better position than entering a trade. To achieve this, a trader must:
· Identify potential risk of the trade using tested strategies / plan
· Secure a good entry position
· Manage the position (and your emotional response) with a clear mind
· Recognise when opportunity cost turns averse and exit the trade
It is often the last task of “Knowing When To Exit A Trade” that is failed by traders and investors, but it appears to be the least acknowledged task of the above. This task does not have to be difficult, but it requires an increased awareness of price action to identify reversals or changes in trend. The notion obviously adapts to what type of trading or investing approach that one prefers, though the fundamental aspect of adding effective existing strategies remains the same, in order to gain maximum opportunity.
Early warning signs such as major reversals and failing rallies can be realized from a change in market conditions.
This article will look further into this subject and also the red flags can offer a timely indication to exit the trade and secure a profit.
It is not uncommon to hear of traders spending time to perfect their entry triggers only to blow their account on taking poor exits. A good starting point is for the trader to identify what time frame aligns best with the trader’s approach.
Types of Investing / Trading summarised below:
· Day Trading: Hours
· Swing Trading: Days
· Position Trading: Weeks
· Investing: Months
The next element leading on from the above will see the trader establish the reward / risk targets and an approximated time period that this will play out (in relation to the time frames above). The next resistance target on a chart will typically offer a trader’s reward target, with a point below support of even an adverse wick being the point in which a trader’s trade idea is proved wrong, which will be the risk target. The RR ratio (Position Size = Risk Amount / Distance to Stop Loss) can then be calculated to see if this is a trade worth entering.
We will now enter two scenarios based on opposing directions of how a trade can go.
Scenario One — “The Hero Trade” (Market Timing)
Source: The Cartoon Funny Blogspot
Price is moving effortlessly towards your reward target. So, what do you do? Well, there are a couple of available options. The first is to do nothing and exit the position at your intended target. The next option is to assess the strength of the trend and also notice the position of the next resistance level. If price continues to show strength to your favour, this could be left to exceed your intended target, with the placement of a stop loss at the level to prevent a sudden change trend. Some traders have preference to combine these approaches and close at their intended target but re-enter on a strong trend after it breaks through the resistance level.
Of course, not every trade will have the luxury of a strong trend and may advance at a much slower rate. If the trade is advancing slowly towards the target, a trailing stop, (which is a stop order set at a marked percentage or monetary amount away from the current market price), can be placed below the current market price to protect any gains in an open trade.
Scenario Two — “The Zero Trade” (Stop Loss Placement)
Source: Hit & Run Candlesticks
Not every trade goes accordingly to plan, despite what the fiction that is often relayed, by those glamourising trading, as a quick fix money scheme. Some of the most successful traders have what appear as mediocre at best strike rates, if you were drawing comparisons to winning success percentages of trading to other disciplines in life. So, “with the cards being stacked in favour of the house” it is prudent to protect your capital with the placement of a stop loss, as the probability is high of a trade not going in your favour.
The stop should be placed at a level that marks the trade idea as being technically invalid. New traders often make the mistake of placing a stop at an arbitrary level based on a set percentage. These placements are nonsensical, as they do not follow any trends, volatility or characteristics of the market. The stop placement should be established based around price action swings, with the use of trendlines to firm up the level. The market does not care about your percentages!
There is an art to firming up a good stop placement. Algorithms (a set of predetermined instructions for accomplishing a task) will carry out stop hunts to take out stops at levels where “logic” says it “should” go. In reality, stops should be placed away from these levels as this is where many retail investors will be placing their own stops. If you are live trading it is possible to enter trades after the market passes a contested level.
Scaling an Exit
There is a further option available to scale an exit, though this method is often confused and misused, especially by newer traders. For example, a correct scenario of implementing this would be to raise your stop to break even if price is strongly trending in favour of your trade. As prices closes closer to your target, you have the option to take profit in tiers depending on the size of your trade. It is possible to combine with a trailing stop to avoid the market turning against your trade idea.
A newer trader could misuse this method and automatically think it is correct to always manually move your stop to break even, which is obviously not the case. This strategy does not allow for fundamental occurs that drastically affect the market in an opposing direction to your trade. In this case exit the market and reassess thereafter.
Early Warning Signs
If you analyse markets close enough, you will notice that they have a tendency to range for significant periods of time. The market will settle and consolidate after a strong trend into trading ranges. Natural market moves will then see this range becoming a local top or bottom depending on the direction of the next move out of the range. The ability to understand price action will allow the trader to establish an early warning of a breakout of the range in either direction. Price action may also through in some curve balls with failed breakouts that are generated by exploitative algorithms looking to take out investors or short sellers depending on the market trend.
If you find yourself on the wrong side of breakout or breakdown of price, it is prudent to exit and reassess if a suitable entry can be gained, in accordance with your initial trade idea and the underlying trend.
Typically, a trader may have a different method to another trader, depending on what they feel works best for them. Some traders look for relationships between moving averages as an early warning to trend changes. This can happen when short term averages (such as the 21 day EMA) through medium or long term averages (such as the 50 day EMA and 200 day EMA respectively). This method doesn’t work for everyone as some argue that moving averages are lagging indicators, while it works very well for others. Price action can also be used alongside moving averages when the slope of the moving average changes from the direction of the market to sideways, indicating that a possible change in direction could be on the horizon. This is most effective when using medium term moving averages.
Other traders prefer to use volume as in indicator for identifying trends using volume. This can be done by assessing the average daily volume over a mid-term period, then look to identify breaks up or down from the average to identify high or low volume days, depending on a long or short trade opportunity. This can be aligned with a swing breaking an identified support or resistance level. During uptrends or downtrends on-balance volume can be used to identify buying or selling pressure after periods of accumulation or distribution. A change in direction can be recognised when accumulation or distribution patterns begin to be contested through profit taking or value buying, depending on market trend direction. There are also anomalies to the above, such as climax days. This happens when new highs or lows are created through sessions that produce daily volumes of least three to five times the average. It also appears at the end of an extended price swing.
A trait that the best traders can master is their own self-awareness and they can actually employ this as an early warning trigger. Typically, a time when a trader begins to gloat in trading chats or on social media of their trade entries or profit and loss, then it is normally time to exit the trade and reflect. A top trader will reflect within oneself using underrated self-awareness tools such as a trading journal. If a trader is lacking in self-awareness, then they are likely to repeat their flaws. They could attempt to maintain confidence by overlooking vulnerabilities in lieu of acting upon them. A self-aware trader will have a process to work on themselves in order to have a detailed and refined understanding of their trading process. Humility and awareness are key.
A quote by Bertrand Russell is very apt when considering the trait of self-awareness, “The problem with the world is that the intelligent people are full of doubts, while the stupid ones are full of confidence. The whole problem with the world is that fools and fanatics are always so certain of themselves, but wiser people so full of doubts.”
The fast-moving nature of electronic markets don’t always present the perfect position to match your trading criteria, and it is a skill to have the ability of knowing when to exit a position. Adhering to opportunity cost analysis and observing early warning signs will allow the trader of adverse change in market conditions that often drain traders of closing a trade in a profit.
This article was written and published by Strong, you can find his twitter here or you can check out his amazing medium page where he shares a great deal of knowledge content based around trading, mentality and controlling emotions. We are super grateful that Strong allows us to house some of his content on our platform! Please go check him out!