John Kicklighter, DailyFX.com

Question:

How do I know when I should exit a trade?

Are there some rules on this that I can follow?

Response:

Many traders approach their strategy with one thing in mind: establishing the qualifications for entry. The ‘edge’ if you will. From there, the trade should take care of itself, right? Not really. How you manage a trade after it has been taken is perhaps the most important dynamic to a true strategy (as opposed to approaching the market trade by trade). Once in a trade, you have cast your line; and the result  will ultimately be a gain or a loss. Yet, unless you think this one trade will make you wealthy enough to retire after its closed; it is important to establish some consistent (if flexible) parameters for when you should exit the market with a profit or (preferably) a tolerable loss. What are the considerations you should account for when looking for the exit?

The first rule for plotting your exit is to have some notion of how you will get out of your trade before you even put it on. For those traders that are utter beginners, we usually hammer home the concept of defining a hard stop and target before you even enter a position. This is just a suggestion to instill good habits – namely: don’t trade with emotions. That being said, absolutes aren’t conducive to trading. You need to retain some level of flexibility for a market and financial structure that is adaptable. Nonetheless, we still need to establish some ground rules; because a preconceived notion of an exit can bring significant clarity to the success or failure of your trade. It is a good exercise to ask yourself in the middle of a trade whether this is a good position or not and why. Even those supremely confident in their trading skills and can answer the first question will still have to take a cold hard look at their reasoning.

When going about establishing exit points, you should consider a ‘graceful’ exit whether you have a winning or losing trade. Both scenarios should be accounted for on the initial development of the trade. A stop is pretty straight forward. If the market has broken a specific technical level or the notional loss on the position breaches your tolerance level, it is time to exit and reassess (never right-off a pair altogether, you will have to trade the pair again sometime in the future). Yet, I like to combine technicals and money management when establishing my own stops. I will typically only risk 1 to 5 percent of my total equity on any single trade. That is a hard fast rule. Now, I look at the technical scenario. If a reasonable place to set my stop is too far from the entry or it happens to be very close, I will use that level and simply alter my position size such that my total risk will always fit that 1 to 5 percent rule while maintaining the technical setup.

Targets are a different story. As it is often said: “you should cut your losers and let your winners run.” This is advice to live by; but how? Well, we have capped our losses; but balancing your take-profit is more difficult. The first thing to do is refer back to your stop. How much risk did you take on the outlay? Your trade should be able to compensate for that risk and more. But, how do we do this without leaving the trade open to emotions taking control and stopping a trade out too soon or keeping it on for so long that it reverses? What if we set our first target near or equal to the initial risk taken? This target should be set within meaningful technical bounds so that nothing prevents the setup from playing out aside from natural market forces. With this approach, we are trading with multiple objectives. That  first target is to simply reduce the risk with the trade. A big emotional weight will be lifted when you book this allotment. To further lift the haze of fear and greed, we can trail the stop on the remaining portion of the position. Now, with the remaining half of the position, you can ‘let your profits run.’ If you initially entered a trade with the belief that it would force a medium-term breakout; and you just took half profit and curbed your risk. You can now wait for that move to happen with a cool head. For the second half, it is important not to just let it drift. Have a target level or wait for momentum to turn against your position (the end of or pause in a trend).

This further leads us to consider: how long should all of this take? Too few people actually consider when they go into a trade that it should take X-number of minutes, hours or days. Typically, they wait until their patience is tested; and that is when their good trading habits start to break down.  A simple way to establish how long a trade should take is to first consider what time frame you are looking at your charts or fundamental developments. If you are waiting for global economic activity to accelerate, then you are talking about a broad driver that can take weeks or months. If you are looking at a range and potential breakout candidate on a daily chart that has taken three weeks to develop, allow for at least a couple days. If you have watched a repeatable pattern develop on a five minute chart; your scalp should develop over approximately the same time as the previous pattern. And, what should you do after your time is up? Exit. Don’t think twice. Just exit the trade and reassess when that pair will once again be a good long or short.

By John Kicklighter, Strategist at DailyFX.com