How To Determine Your Exit Strategy
Traders will often spend a lot of time perfecting their entry strategies, but the most crucial point in a trade is knowing when to exit. This should not be left to the inspiration of the moment, but needs to be determined in advance. Here is a look at why you need an exit strategy, and what you need to consider when determining yours.
Why do you need an exit strategy?
If you don’t have a plan, you are likely to make a decision under pressure, which is not based on rational thought. The dilemma is understandable: if you err on the side of caution and exit early, you could lose out on a good profit. On the other hand, if you go for more, and hold a position too long, you could end up taking a loss.
To avoid such an emotion-led response, it is important to implement a well thought out exit strategy. There are some steps you can take to help you exit a trade as close to the profit peak as possible. However, there is no one particular rule that works for everybody; your approach will be determined by your individual circumstances and trading goals.
What do you need to consider for your exit strategy?
This will depend on your level of trading experience, your risk tolerance, and whether you are looking for a short-term or long-term trade. Newcomers are best sticking to a simple strategy, which will not necessarily be any less effective than a complex one. Here are some of the most frequently used exit techniques in forex trading.
One of the most common strategies is to place a ‘stop-loss’ on the trade before the entry point. This automatically triggers an instruction to sell the currency pair at the market price once a specified price is reached, and acts as a buffer zone against substantial losses.
For example, if a trader has a position worth £50, they could enter a stop-loss order to sell at £45, in order to avoid any further risks.
If you have a long position that is making a good profit, it is possible to move your stop-loss order, in order to protect your profits, should the markets suddenly take a swift downturn. A short position which is performing well can also be protected, by moving the stop-loss from the loss zone, and higher into the profit margin.
A stop-limit order is used in a similar way to a stop-loss, and is designed to mitigate the risk of uncontrolled losses. The forex markets can be very liquid and volatile, so unless you are an experienced analyst, stop orders are a very useful tool. Unlike stop-loss orders, stop-limit orders are only filled if the market trades at the pre-determined price.
The advantage of this is that the price limit is guaranteed, unlike with a stop-loss which sells or buys at the market price, not the specified price of the order. The disadvantage of a stop-limit order is that the trade may not be executed at all, if the conditions are not met. Should the markets take a sudden plunge, substantial losses may occur.
If the trader is prepared to sit and wait out the downturn, the price may well rise again within a short time-frame. However, it’s worth bearing in mind the factors that influence the markets to predict how likely this is to happen.
For example, foreign exchange prices are strongly linked to inflation rates, so study what the long-term outlook is for the countries relevant to your currency pairs. Other factors to keep an eye on are the unemployment rates, level of public debt, and current level of demand for the leading exports of a particular country.
How to set your stop order levels
Knowing why to use limit orders is important, but it raises further questions about how to use them to maximum effectiveness. Too cautious, and the potential to make gains is limited. On the other hand, too wider margin can leave the trader vulnerable to substantial losses. Some of the decision depends on your personal risk tolerance.
Support and resistance levels
To refine your process further, some technical analysis is useful. One of the key methods successful traders use to identify price points is monitoring support and resistance levels. Support refers to the price level where a downturn in the market is expected to pause, because of favourable conditions.
A resistance zone is where an uptrend in the market is predicted to pause. Traders watch support and resistance levels to judge which way the markets will turn, predicting whether the price will remain held by the support or resistance level, or whether it will break through.
The concept is rather like a rubber ball bouncing off a floor, and hitting the ceiling. Market forces can speed up or slow down the pace. If the direction of travel is wrong, the position can be quickly closed to minimise losses. Support and resistance levels can be monitored visually on price charts, which track the timing, pace and volume of support and resistance.
Moving average trailing tops
It is important to be aware of moving averages when making predictions. This is a way of tracking whether a long-term trend is moving up or down, regardless of day-to-day fluctuations.
If a trader is looking to make a profit on a long-term position, they will track the moving average, and place a stop order just slightly below the level of support. The theory is that a trader will buy currency pairs when the price is above the moving average. A trader looking to sell will take advantage of a price below a moving average.
When the trend begins to shift in an unfavourable direction, the trader will close out their positions, to protect profits or minimise losses. This type of exit strategy is known as a moving average trailing stop.
Some traders have a deliberate policy of holding positions for a very short time only, usually just seconds or minutes, with the aim of making a small profit. This process is referred to as scalping.
Day-trading is another type of short-term trading strategy, where positions are held for one day at most, and usually closed within hours, or minutes. It’s a strategy often used by novices, because the barriers to entry and risks are lower, and you need less market expertise to be successful.
More experienced traders also use scalping, because it allows them to take advantage of the high volumes of leverage available, particularly in funded trading accounts in the UK. This means that large position sizes can be taken for a fraction of the actual cost, offering the potential for lucrative profits in return for a small investment.
Traders will often wait for an event to occur that influences the movement of the forex market, such as the release of unemployment rates, or interest rate announcements. This increases the potential rewards, but the downside is that the risks are also maximised. It is safer to trade the most liquid pairs, at the busiest times of day.
There are numerous strategies for scalping. One of the most common is to study support and resistance trends, on a short time frame rather than a moving average. The trader will attempt to buy in a support zone and sell in a resistance zone.
A more ambitious trader may look for statistical anomalies to take advantage of, for example; the time of day, or day of the week, could cause very brief periods where the chart patterns top out or pull back. A riskier strategy is to take a position in the opposite direction of a trend and wait for pullback. This is known as countertrend trading.
Average True Range (ATR)
The ATR is a type of technical analysis, used by forex traders as a market indicator. It measures market volatility from a series of indicators over a 14-day moving average. It originated as a method used in commodities trading, but it is now also widely applied to forex trading.
It is important to know that ATR only measures the market volatility, and not the prices, so it should be used in conjunction with other indicators. When determining how to fix entry and exit points using ATR, an experienced trader will calculate the risk to reward ratio.
Short term traders may prefer to use a five-day period or less, as ATR can be used with any timeframe. A stop-loss order should be set at just higher than the ATR. If there is a large ATR, then this means that the market is highly volatile, and the wider the range between the entry point and the stop loss order need to be, to secure a realistic profit margin.