Methods For Closing Trades

Exit Strategies

Your exit strategy is arguably as important as your entry. This is a key parameter that people tend to overlook and not focus on as much as they should. Entering a position is relatively easy, the difficulties lie in holding winning positions long enough to maximise profits and cutting losses fast enough to minimize losses. There are many ways to exit a trade, but we will focus on 4 here.

1)Stop losses

2)Trend reversal

3)Time-Based

4)Take profit

1)Stop loss

You may not immediately associate stop losses as an exit strategy, but they are by far the most important exit strategy. Cutting losses early is key to any profitable strategy, so making sure you place and stick to your stop-loss is extremely important. To determine your stop loss placement, see the stop loss guide.

2)Trend reversal

A common and very effective exit strategy is to close out after the trend begins to reverse. This typically comes in the form of a moving average cross, or a price cross. The benefit of this strategy is it tends to keep you in the move for a long time.

The example below is for AUDUSD, using a 50-day Bollinger breakout strategy. Theselltrade is closed the first day the price CLOSES above the moving average. For a buy position, the opposite case would be true. Sometimes the price may bounce off the moving average, but close below and reassert the trend. As such, from our tested systems we determined it is more profitable to wait for the bar to close above rather than just the high of the day being above.

Using our trading system, our stop loss would be 1.4 ATR away from the open price. Therefore, the stop loss level is at: 0.9202 + (1.4 x 0.0055) = 0.9279. For a $100 position risk, this equates to $1.3 profit per pip (a price move of 0.0001).

The opening price is 0.9202, with the close price at 0.7880, a profit of 1322 pips! This is equal to a profit of $1719 from the initial $100 risk. You can see how powerful it is to stay in a move for the whole length. This is an enormous benefit of the trend reversal strategy.

3)Time based exits

Although time-based exits may initially seem random, they can have an incredibly positive influence on a system. Remember, all price action is all based on human behaviour. As such, trends are a function recency bias (remembering more recent prices) and emotions. There is only a certain amount of time people will watch the market go in a single direction without a correction before they get greedy and take profit, which results in a price correction.

Let me use an example. Imagine you buy gold at $1000, and the price quickly moves to $1010, then $1020, then $1030 etc… until after a few weeks the price is up at $1100 with very little evidence the price will pullback. It’s likely you’ll expect the price to come back eventually, and so you will cash in your profits early. This happens on a large scale, which is why the markets tend to move like ‘waves’, first riding up, then pulling back, riding up etc…

One benefit of time-based exits is that for smaller moves, you can often close out at a better price, without having to wait for the price to completely show reversal signs. Another advantage of the time-based exit is that once you have closed out, you can re-enter a trade once the price breaks out again as you have no exposure. You may also have more money in your account (provided you have profited over the period). Therefore your position size on the second trade will be larger which means your second profit is more likely to be even bigger. Let me demonstrate this with the same 50-day Bollinger breakout system as above, but with a 20-day trade exit (closingeachtrade 20 days after opening the position).

Imagine we are trading a $5000 account with a position risk of 2%(or $100 risk per position). Over the same period, using a time based exit strategy we actually enter 3 positions, instead of 1 position with the trend reversal exit strategy.

Position 1: The risk on the first position is $100 for September 2014 on the example above. The stop loss is placed the same as before, and we make $689 profit on the first position.

Position 2: Again, the risk is 2% of the account. But now we are selling in late December 2014, and have already made $689 in this period(+14% on the account) in this market alone! You will also be tracking many other markets, so lets imagine the account is up 25% to $6250. That means the position risk is now 2% of this higher value, giving $125risk per position.

The ATR here is 0.0105, slightly wider than the first position due to higher volatility, so the stop loss is at 0.8677 with the pip value is at $0.85 per pip. We make a 429 pip profit from the move, equalling $365.

Note: To change the pip value for a wider stop loss, you do this by varying the total position size.

Position 3: One drawback of this method is that you dip in and out of the market more often during longer trends which can sometimes lead to a losing position being entered nearer to the end of the move. In this case, a final position is entered at a loss of $125.

Overall, the strategy makes $929 profit for the period. This is not as good as strategy 2 in this case, but still very good. Time-based exits do not immediately seem like a sensible way to close a position, but using the right length, they can be very powerful tools.

The number of bars (days, hours, minutes, depending on your timeframe) after which the position is closed is also important. If you close after too few bars (1-10) then you don’t give the market enough time to run, but if you wait too long (20+) you give the market more time to come back and reverse. We found somewhere between 10-20 works best. Whichever you choose, make sure you are consistent and use the same number of days, hours, minutes etc for every trade you make.

4)Take profit

The take profit method involves placing an order to close the position after the price has moved to a desired level. This gives you a fixed risk/reward and is typically set around 2-3 times your stop loss width in direction of the position. This is useful for some trading styles, but NOT FOR TREND FOLLOWING. I do not recommend this as an exit strategy for our systems, or any other trend following system. I never set a take profit.

The reason for this is that by setting a take profit, you are guessing how far you believe the market could move. This means that in small moves your take profit might not be reached and you could potentially miss the peak price of the move and eventually be stopped out. In big moves, you will take only a small portion of the profit, where big moves can be above 10 times your stop loss, but you have just closed at 2-3 times your stop loss, leaving a lot of money on the table.

This can be shown again using the same example chart. Imagine you a have set your take profit at a fixed risk to reward of 2:1. That is, you will close your position when you reach $200 profit with your $100 risk.

For the exact same move, a take profit strategy makes only $325. Comparing this to the $1719 and $929 profits for the other methods, you can see why this is not a good technique. A take profit strategy can feel like a more psychologically satisfying exit strategy. This is because you can visualise your exit price on the charts with a take profit exit, whereas with a time-based exit strategy the final price is completely unknown, which is mentally harder to deal with. However, just because it feels good, does not make it profitable. You need to let the market tell you when it is ready to go no further and capitalise on big moves. Fixing the profit potential of a trade will destroy the risk-reward and profitability of the system with trend following.

Summary

1)Stop losses are the most important exit strategy. These are an absolute must.

2)Both trend reversal and time based exits are very effective methods to exit a position

3)Take profits are not effective for trend following strategies. Set your take profit as far away as possible to make sure it doesn’t accidentally get hit, then exit using a different strategy.