When beginner traders start looking for that magic "make me a bucket load of cash" trading system, quite often the last thing thought about is their exit strategy.
Usually the first and most important thing on a traders mind is when to enter a market, forgetting that you actually make bugger all money if you can't execute and exit as precisely as you entered.
There are three main scenarios that a trader will find themselves thinking of their exit:
- A trade has moved as expected and they are in profit
- A trade has moved opposite to what they expected, and they are in loss
- A trade is dancing around the neutral zone of their trade
At first glance, you would think the easiest scenario of the three to exit under is number 1, i.e. when you are in profit, after all you are "cashing in" so how hard can it be. In fact, in reality all three can be as hard as each other.
The reason?, like most things with trading, it comes to emotion.
Below I have added the underlying emotions that might stop you closing a trade under these three scenarios:
- A trade has moved as expected and they are in profit (GREED)
- A trade has moved opposite to what they expected, and they are in loss (OPTIMISM)
- A trade and dancing around the neutral zone of the trade (FEAR)Let's look at them one by one.
Cannot close a profitable trade (Greed)
Everyone fights greed every day in life, always "wanting" rather than sticking to what you actually "need".
It is part of a materialistic modern day culture that most of us are subject to.
Trading is no different, and it is usually greed that can turn a nice logical, well planned and profitable trade into a losing one.
When this happens, a trader reacts two ways, one, they are distraught at themselves for letting it all get away, or two, they tell themselves "well I was right with my prediction, the market just had it in for me".
Think of this, you set up a trade, monitor the setup closely, wait for the exact time to enter a trade, calculate your stop loss, your order is hit and you are in the trade.
The price action moves beautifully, moving quickly towards your scantily thought about target (if you set one), and the sense of delight sends your brain into overdrive, working out the profits, imagining the Ferrari soon to be in the drive-way, wondering if 2000 pips has ever been done in one day.
This is when you know you are in some trouble, this is when greed has started to set in, you remove your profit target thinking "let's see how long this goes", you don't move your stop loss, cause you don't even contemplate that it might reverse, and you "go for the ride".
A common saying is "cut your losses, and let your profits run" (or something like that ;)), and it is a very good theory that should be followed.
However, how do you ride your profits, without risking a reversal that you will undoubtedly put down to "a correction that will soon move back my way".
Personally I look at it this way:
- Move your stop loss to break even or better as soon as is logically possible without risking being whipsawed out, that will ensure you will not lose money on the trade, ease the stress, and bring peace to the world (ok maybe not that). I take the view of never let a winning trade turn into a losing one so at least lock in 1 pip if it makes you feel better.
- If the move was stronger that you anticipated, and you had a 20 pip profit target. Remove your profit target, and move your stop loss to the profit target as soon as possible. What you effectively have done is close your trade (because your stop loss is at your original target) and you are letting your profits run at the same time, two for the price of one, bargain!
- Continue to follow the trade with your stop loss, and remember, 20 pips was your target, be satisfied with whatever you can get after that, but don't take any less. You can use one of the many trailing stop techniques to do this or look at the parabolic SAR indicator.
Cannot close a losing trade (Optimism)
I was tempted to use the word "Dillusion" for this one but felt perhaps that is a little harsh, you know the deal, you enter a trade, you set a 25 pip stop loss, the trade moves the wrong way and you are -20 on the trade, you look at the chart again frantically, and optimistically think "Oh of course ... I should have set the stop loss beyond that resistance level from the year 1967, what was I thinking" and you change your stop loss, making it -35.
The price continues to move in the wrong direction, and you either cop a -35 pip loss instead of -20, or you remove your stop loss all together and spend the next week driving everyone nuts asking "will the EUR/USD go up?" to every trader in the chat room.
... Some may say, that they removed their stop loss and eventually, their -100 pips turned into +10, so there .. stick that up your jumper ...
What you do when you move a stop loss further away from entry, is completely change the ratio of the trade you entered. What was originally a 2:1 trade, i.e. your potential gain was twice as large as your potential loss, becomes a 1:1 trade, which is just asking for a margin call very quickly.
My advice on this?
NEVER NEVER (I think that is pretty clear) move a stop loss further away from your entry, you can move it closer or break even if you wish, as this improves your risk/reward ratio, but never away.
Some may say, that they removed their stop loss and eventually, their -100 pips turned into +10, so there .. stick that up your jumper ... the only problem is, that while they waited the week out waiting for the price to turn around (sometimes it never does .. look at the USD/JPY at the moment) they have tied up the entire margin, meaning they are locked out of many many more potentially profitable trades. So while you might end the week at +10, in the meantime other trades cut their losses at -20, entered 15 more trades in the week, and finished +100 for the week and at the same time learnt a hell of a lot more.
You want to close a trade dancing around the neutral zone (Fear)
This one is different, this is when you have a trade at +1, 0 or -1 pips, right around your entry, and it hangs there for quite a while, what do you do?
Do you take a really small gain of +1 "just in case" it turns? Personally, and this one is up to you, I say never close a trade around the neutral zone of a trade, the ultimate aim of a trader, is to see a movement before the majority of others, you can then get in early, and when the others have caught up, let them make you money.
If you have spent the time analyzing a trade, trust your judgement, if you analyzed correctly, you may have got in early and it will take some time for the others to catch up.
Don't be fearful of a losing trade, instead trust what you saw in the first place when you placed the trade.
Sure there will be times when you end up losing, but if you cut your losses and let profits run, then you will be well in front in the end.
... If a trade has moved 1 pip past your target (that you have not automatically set), why close it? ...
So that is it, to summarize:
- Always assess your potential profit target, and close, or lock it in as soon as possible with your stop loss.
- Never move a stop loss away from your entry price.
- Don't be fearful you could be wrong, instead be trusting in that you are probably right.
One last little tip, I personally never manually close a trade when it goes my way, my trades are closed either by my profit target being hit as set, or preferably, because I have moved my stop loss to my target and I am following the trade from their on in.
If a trade has moved 1 pip past your target (that you have not automatically set), why close it?, why not move your stop loss to the target point, at which point you the price will either close you at your target as you originally wanted (congratulations, well done, bravo!), or it will continue it's run and you are essentially "playing with the markets money".
This exact strategy turned my trade last night on the USD/CAD from a +45 target trade to eventually it being closed out at +93, it won't work all the time but you have nothing to lose if your target is locked in.