Exit Strategy

In many ways, a good exit is more critical and difficult to achieve than a good entry.
The big difference is that while waiting for a good opportunity to enter a trade, there
is no market risk. If one opportunity to enter is missed, another will always come
along-and a good, active trading model should provide many such opportunities.
When a trade is entered, however, exposure to market risk occurs simultaneously.
Failing to exit at an appropriate moment can cost dearly and even lead to the dreaded
margin call! We actually know someone who made a quick, small fortune trading,
only to lose it all (and then some) because the exit strategy failed to include a
good money management stop!
 

 

There am two goals that a good exit strategy attempts to achieve. The first and
most important goal is to strictly control losses. The exit strategy must dictate how
and when to get out of a trade that has gone wrong so that a significant erosion of
trading capital can be prevented. This goal is often referred to as money management
and is frequently implemented using stop-loss orders (money management
stops). The second goal of a good exit strategy is to ride a profitable trade to full
maturity. The exit strategy should determine not only when to get out with a loss,
but also when and where to get out with a profit. It is generally not desirable to
exit a trade prematurely, taking only a small profit out of the market. If a trade is
going favorably, it should be ridden as long as possible and for as much profit as
reasonably possible. This is especially important if the system does not allow multiple
reentries into persistent trends. “The trend is your friend,” and if a strong
trend to can be ridden to maturity, the substantial profits that will result can more
than compensate for many small losses. The protit-taking exit is often implemented
with trailing stops. profit targets, and time- or volatility-triggered market
orders. A complete exit strategy makes coordinated use of a variety of exit types
to achieve the goals of effective money management and profit taking.
 

Exits employed in an exit strategy:
 
There are a wide variety of exit types to choose from when developing an exit
strategy. In the standard exit strategy, only three kinds of exits were used in a simple,
constant manner. A fixed money management exit was implemented using a
stop order: If the market moved against the trade more than a specified amount.
the position would be stopped out with a limited loss. A p&It rarget exit was
implemented using a limit order: As soon as the market moved a specified amount
in favor of the trade, the limit would be hit and an exit would occur with a known
profit. The time-based exir was such that, regardless of whether the trade was profitable,
if it lasted more than a specified number of bars or days, it was closed out
with an at-the-market order.
There are a number of other exit types not used in tbe standard exit strategy:
trailing exits, critical threshold exits, volatility exits, and signal exits. A trailing
exit, usually implemented with a stop order and, therefore, often called a trailing
“top, may be employed when the market is moving in favor of the trade. This
stop is moved up, or down, along with the market to lock in some of the paper
profits in the event that the market changes direction. If the market turns against
the trade, the trailing stop is hit and the trade is closed out with a proportion of
the profit intact. A critical threshold exit terminates the trade when the market
approaches or crosses a theoretical barrier (e.g., a trendline, a support or resistance
level, a Fibonacci retracement, or a Gann line), beyond which a change in
the interpretation of current market action is required. Critical threshold exits
may be implemented using stop or limit orders depending on whether the trade
is long or short and whether current prices are above or below the barrier level.
If market volatility or risk suddenly increases (e.g., as in the case of a “blow-off
top), it may be wise to close out a position on a volatility exit. Finally, a signal
exit is simply based on an expected reversal of market direction: If a long position
is closed out because a system now gives a signal to go short, or because an
indicator suggests a turning point is imminent, a signal exit has been taken.
Many exits based on pattern recognition are signal exits.

Exits employed in an exit strategy
 
Money Management Exits
 
Every exit strategy must include a money management exit. A money management
exit is generally implemented using a stop order. Therefore, it is often referred to
as a money management stop. Such a stop closes out a trade at a specified amount
of adverse excursion (movement against the trade), or at a specified price below
(if long) or above (if short) the price at which the trade was entered. A money management
stop generally stays in place for the duration of the trade.

Its purpose is
to control the maximum risk considered tolerable. Of course, the potential risk
may be greater than what was expected. The market could go limit up (or down)
or have a large overnight gap. Trading without a money management stop is like
flying in a rickety old plane without a parachute.
The issue is not whether a money management stop should be used. Rather,
it is determining the optimal placement of the stop.

There are many ways to decide
where to place money management stops, The simplest placement occurs by
assessing the maximum amount of money that can be risked on a given trade.
Another way to set the money management stop is on the basis of volatility.

In volatile markets and periods, it may be a good idea to give trades more room to breathe, i.e., to avoid
having the stop so close to the market that potentially profitable trades get stopped
out with losses.
A good way to set a money management stop is on the basis, of a price barrier,
such as a trendline or support/resistance level. In such cases, the stop also
serves as a critical threshold exit.

As a stop gets tighter, the percentage of winning trades will decrease. The stop
eventually ends up sacrificing most of what would have been profitable trades. On the
other hand, if the stop is too loose, although the winning trades are retained, the
adverse excursion on those winners, and the losses on the losing trades, will quickly
become intolerable. The secret is to find a stop that effectively controls losses with
out sacrificing too many of the trades that provide profits.
 
Trailing Exits
 
A rrailing exit is usually implemented with a so-called trailing stop. The purpose
behind this kind of exit is to lock in some of the profits, or to provide protection
with a stop that is tighter than the original money management stop, once the market
begins to move in the trade’s favor.
Once it is in place, a good trailing stop can serve both as an adaptive money
management exit and as a profit-taking exit, all in one! As an overall exit strategy,
it is not bad by any means. Trailing stops and money management stops work hand
in hand. Good traders often use both, starting with a money management stop, and
then moving that stop along with the market once profits develop, converting it to
a trailing stop.
How is the placement of a trailing stop determined? Many of the same principles
discussed with regard to money management exits and stops also apply to
trailing exits and stops. The stop can be set to trail, by a fixed dollar amount, the
highest (or lowest, if short) market price achieved during the trade. The stop can
be based on a volatility-scaled deviation. A moving threshold or barrier, such as a
trend or Gann line, can be used if there is one present in a region close enough to
the current market action. Fixed barriers, like support/resistance levels, can also be
used: The stop would be jumped from barrier to harrier as the market moves in the
trade’s favor, always keeping the stop comfortably trailing the market action.
 
Profit Target Exits
 
A projit target exit is usually implemented with a limit order placed to close out a
position when the market has moved a specified amount in favor of the trade. A
limit order that implements a profit target exit can either be fixed, like a money
management stop, or be moved around as a trade progresses, as with a trailing
stop. A fixed profit target can be based on either volatility or a simple dollar
amount.There are advantages and disadvantages to using a profit target exit. One
advantage is that, with profit target exits, a high percentage of winning trades can
be achieved while slippage is eliminated, or even made to work in the trader’s
favor.The profit target must be placed close enough so that there can be benefit
from an increased percentage of winning trades and a reduction in slippage, but it
should not be so close that the per-trade profit becomes unreasonably small. An
exit strategy does not necessarily need to include a profit target exit. Some of the
other strategies, like a trailing stop, can also serve to terminate trades profitably.
 
Time-Based Exits
 
Time-based exits involve getting out of the market on a market order after having
held a trade for a fixed period of time. The assumption is that if the market has not,
in the specified period of time, moved sufficiently to trigger a profit target or some
other kind of exit, then the trade is probably dead and just tying up margin. Since
the reason for having entered the trade in the first place may no longer be relevant,
the trade should be closed out and the next opportunity pursued.
 
Volatility Exits
 
A volatility exit depends on recognizing that the level of risk is increasing due to
rapidly rising market volatility, actual or potential. Under such circumstances, it is
prudent to close out positions and, in so doing, limit exposure. For instance, when
volatility suddenly expands on high volume after a sustained trend, a “blow-off
top might be developing. Why not sell off long positions into the buying frenzy?
Not only may a sudden retracement be avoided, but the fills are likely to be very
good, with slippage working with, rather than against, the trader! Another volatility
exit point could be a date that suggests a high degree of risk, e.g., anniversaries
of major market crashes: If long positions are exited and the market trends up
instead, it is still possible to jump back in. However, if a deep downturn does
occur, the long position can be reentered at a much better price!
 
Barrier Exits
 
A barrier exit is taken when the market touches or penetrates some barrier, such as a
point of support or resistance, a trendline, or a Fibonacci retracement level. Barrier
exits are the best exits: They represent theoretical barriers beyond which interpretation
of market action must be revised, and they often allow very close stops to be set, thereby
dramatically reducing losses on trades that go wrong. The trick is to find a good
barrier in approximately the right place. For example, a money management stop can
serve as a barrier exit when it is placed at a strong support or resistance level, if such
a level exists close enough to the entry price to keep potential loss within an acceptable
level. The trailing exit also can be a barrier exit if it is based on a trendline.
 
Signal Exits
 
Signal exits occur when a system gives a signal (or indication) that is contrary to
a currently held position and the position is closed for that reason. The system generating
the signal need not be the same one that produced the signal that initiated
the trade. In fact, the system does not have to be as reliable as the one used for
trade entry! Entries should be conservative. Only the best opportunities should be
selected, even if that means missing many potential entry points, Exits, on the
other hand, can be liberal. It is important to avoid missing any reversal, even at the
expense of a higher rate of false alarms. A missed entry is just one missed opportunity
out of many. A missed exit, however, could easily lead to a downsized
account! Exits based on pattern recognition, moving average crossovers, and
divergences are signal exits.