Exiting a trade: The last but definitely not the least

Exiting a trade. This is in my opinion the most important part if we want to define what is a winner and what is a loser. But its a shame that most traders keep formulating entry plans, and trying to find the perfect entry signal, while paying very little or no attention to exit. New and novice traders mostly have a very well thought of entry plan. But once the stock or future starts moving in their direction or against, they have no idea what to do next or how to exit.

A successful method of trading be it discretionary or mechanical, can be defined broadly in 3 steps.

• Running away from Loss
• Letting the profits run
• Protecting the profits

As you can see all the 3 steps above are related to exit. That is how important exit it. And unfortunately its kind of inversely proportional to how much attention most traders pay to it.

Without having a proper exit plan, gives rise to a number of issues and the trade turns into all but hope. The mind starts playing games with plans of exit. The following things might happen.

Exit Plans in mind:

A trader enters a position and it starts moving in their direction. Without an exit plan this is how the mind suffers.

1. The position moves in the traders direction. The trader keeps thinking and hoping for a little more.
2. The position then reverses after going in traders direction, now the trader is in a guilt trap. The thought in mind is “what if” and the plan is to exit once it goes back to the previous profit position
3. The position is back at entry. Now the trader has no idea. They recheck the entry find it was perfect, so keep telling themselves that stock will turn, and maybe they will exit with a little profit.
4. Stock moves more against the trade. The trader freezes. Maybe exit when its back at entry, and at least not make a loss if no profit can be made.
5. Stock keeps going lower, hope is lost. What was supposed to be a short term trade has turned into a long term investment. Maybe buy more to average?

The above is just an example of how a trading position might unfold without a proper plan for exiting the trade.

Pulling the trigger: Exiting a trade:

In a Mechanical System the exit is always properly defined and in fact you can have multiple conditions for exit. At a very high level there can be 3 types of exits.

1. Stop Loss
2. Target
3. Trailing Stop Loss

Stop Loss:

A stop loss is one of the most essential elements of a trading system. Its a point where we accept that a particular trade has failed and get out by exiting the trade. We take a loss and say, “Bye bye, we will come back stronger some other time”. The process of acceptance of risk comes down in the end to respecting the stop loss. A lot of traders start doubting their initial Stop Loss once price comes close to it. This should never happen. Stop Loss is in fact not a loss, its a way to stop a loss at the point of acceptable risk.

If the fear of your stop loss being hit is giving you sleepless nights, that simply means your position size and risks are far too high for the trade. Our Stop Loss effects our position size equally as our risk management.

Target:

Target as the name suggest is what you got in the trade for. Its a fixed point or rule at which a trader books his profit and exits the trade. Targets can be fixed as a ratio of the risk, that is if I risk 10 I might want a target of 20 or 30 depending on the strategy. Target can also be based on technical analysis. A simple example would be having targets based on lines of support and resistance.

New traders have the attitude of exiting too early, keeping short targets and large stop losses. Some exit even before targets are met. They feel they are protecting the profit when actually, it is an act of leaving a lot on the table. Personally I am not a target fan boy as I feel it restricts the potential of a trade by giving it a limit. Though targets can have a good use for partial profit booking. Exiting the trade completely at target is not something I advise. Though in trading systems like mean revision where we enter at extremes, and exit when market is back in range zone, this could be a good method to exit.

Which brings us to the third method of exit, the trailing stop loss, my favourite one.

Trailing Stop Loss:

Trailing Stop Loss is basically a mix of target and stop loss. In this method instead of exiting at the target, you modify your stop losses and keep moving them in the direction of your trade. Trailing Stop Losses are the perfect method to cover 2 important steps in a successful trade.

1. Protecting your profits
2. Letting your profits run

When we are trailing our stop loss with the price moving in our direction, we are not booking profits early thereby we are letting our profits run. Also if the markets turns around after reaching a point, our stop loss now might be well above our entry to protect some of the profits. This is an ideal way for exiting in trend following systems.

Another advantage of trailing stop loss is sometimes even when we are not making profits the losses might be considerably reduced, due to trailing stop losses.

As an example say in our system of EMA crossover, let us trail 50 EMA line as a stop loss in our system. This will move up as soon as our entry his hit. Thereby bringing the new Stop Loss just after entry to an amount considerably lower than our initial risk.

Exits are huge topic and needs wider coverage. Multiple signals and rules can be used in exits. Partial Profit booking is a whole topic in itself. This is the crux of trading. Getting out is when finally the money is added or subtracted from your account. So be sure to spend a lot of time thinking this out when making your own trading system.