“Don’t worry about what the markets are going to do, worry about what you are going to do in response to the market.” – Michael Carr, Market Wizard
After you get into your trade, different things happen. Very rarely does your trade go in a straight line to your profit objective.
So, if you only have one tool in your toolbox, you are going to struggle to react effectively to what is happening in front of you. If you only have a hammer, everything is going look like a nail, even when your trade is screaming for a screwdriver or a measuring tape.
Instead, pack your toolbox full of different tools for different scenarios. That way, when the moment calls for it, you can appropriately make the right decisions about when to stay in your trade and when to exit, based on what the market is doing at the time.
In general, you will want to have the following types of exits at your disposal:
- An exit if the trade reaches your profit objective
- An exit rule in case of reversal right after entry
- An exit rule for an intra-trade drawdown
- An exit if the trade moves steadily in your favour and then reverses
- An exit for a fast moving market in your favour
- An exit for a fast moving market against you
- An exit for once the price gets close to your profit objective and starts to fall away
- An exit rule for chart patterns that signal reversals
- An exit rule if fundamental or sentiment conditions change
Sometimes your exit will be to do nothing, but you should always have a plan for what you are doing with the trade.
Simple entries vs. complex exits
In the lesson 10, we learned that your actual rule for getting into the trade should be simple.Complexity is the enemy of decisiveness.
Why, then, am I saying you should have a complex exit strategy?
Each component of your exit strategy on its own is quite simple, yet combined together they form a complex exit strategy. Contrary to the popular wisdom that a simple trading plan is better, exits need to be able to cater for many different circumstances.
It’s better for you to have a set of clear rules that will allow you to manage risk and protect your profits depending on what the market does.
The market is going to force you to make decisions
Throughout your trade, the market is going to throw you all sorts of different scenarios. It is going to force you to make decisions about what to do constantly.
Often, it will be best to sit tight and do nothing, but there will be times when action should be taken. It is at each of these “decision points” that your complex exit strategy comes into play.
You will need to assess the current market, and apply the right tool for the job to manage your trade properly. A decision point could arise because of market action, or it could arise because a pre-planned price was hit.
A reversal pattern could form, or the price could reverse a number of R-multiples, and you need to decide if you are going to stay in the trade, or if it’s time to exit or reduce your position size. Be aware that these decision points are going to happen, and be ready to act when they do.
Trading what’s in-front of you is all about being prepared.
Learn to expect what comes next and play the probabilities
“Your job is to follow the system. If the system does something that results in losses. That’s just an expected part of the system. Your Judgement might be on the line over the performance of the entire system, but there is no sense in which your judgement is on the line on any single trade.” – William Eckhardt, Market Wizard
In developing your complex exit strategy, it is important to understand market types. If you know what market type the currency pair is in, then you can predict what might follow next. For example a bull normal market will often transition to a bull volatile and then a volatile sideways phase before falling into a bear market.
If you know this is the probable outcome you can plan your exits accordingly.
Developing your complex exit strategy
“I let the market dictate to me how I should be trading, not my macro views of what I think the market will do.” – Larry Benedict, Market Wizard
As you develop your trading system, you will need to build a set of exit rules that fit you, and the other components of your trading plan (such as your entry and trading timeframe). Let’s look now at each of the specific exits you will want to be able to call on.
“I always take money off the table when it’s in my favour. Always, always, always.” – Jimmy Balodimas, Market Wizard
When your trade hits your profit objective you have a number of options:
- Close the position manually
- Have a set profit target to automatically close the position
- Tighten the stop loss and let the position run
- Take off some of the position and let the rest run
- Make no changes and continue in the trade
- Wait for a reversal signal
It is a balance between letting your profits run and locking in your gains. What you do here will very much depend on your trading style and personality.
Profit objectives serve as a guide for your trade.
Your profit objective does not have to be a fixed price, though it can be helpful to have a predefined point when you will exit. If you don’t have a profit objective, i.e. you are following a trend, then make sure your trading decisions reflect that.
A useful profit objective can be a resistance level such as an old high, because the chance of the price reversing increases once it hits this level, as profit taking often occurs. You could also use a Fibonacci level or pivot point. The important thing is to have a logical place to exit.
“Never sell the strongest markets until they fail.” – Scott Ramsey, Market Wizard
One of the cardinal sins that amateur traders make is letting winning trades turn into losing trades. To stop this scenario from happening, you can apply a maximum intra-trade drawdown rule, or amount you are willing to give back in order to achieve further gains.
Generally you would select a maximum R-multiple you are willing to give back.
For example, if you have a 5R winner, you may institute a trailing stop of 2R or 3R so that you lock in some of your profits. If you are going for a large profit objective, you may need to be prepared to give back more R multiples than if you are going for a short profit objective.
Reversal right after entry
“You have to always be pragmatic enough to move with the market.” – Martin Taylor, Market Wizard
You have patiently waited for your entry and seemingly timed it to perfection, but as soon as you enter the market forms a reversal signal. If this happens to you, then you are faced with a decision point.
Do you now exit the position, lighten it, or leave it and see what happens?
There are several chart patterns that indicate that the price has reversed right after entry. These could be:
- A candlestick or bar formation
- A candlestick or bar formation on a different time-frame chart
- A double top or double bottom
- Three consecutive bar or candles in the opposite direction to your trade
- A close below the resistance level for a long trade or above support for a short trade
You may want to apply some or all of these rules. Note that often reversals right after entries are often a good entry for a trade in the opposite direction to your original one.
The trade moves steadily in your favour and then reverses
Sometimes your trade will enter a nice efficient phase where it steadily moves in your direction.
It is easy to continue to hold the position during this period, but what do you do when the market starts to reverse?
Do you exit the trade immediately, or do you decide to hang on until the trend re-establishes itself? It is important to consider your objectives for the trade when you make this decision.
Technical indicators such as Bollinger Bands and Moving Averages can serve as trailing stops to help you manage intra-trade drawdowns.
As a general rule, the longer the timeframe of the indicators you use to manage intra-trade drawdowns, the larger the drawdowns will be (but you will have a greater chance of having a large win).
Volatile fast moving markets in your favour
“The sharpness of the move indicates that volatility has just increased; hence, even a windfall profit might dissipate rapidly.” – William Eckhart, Market Wizard
“One of my rules was to get out when the volatility and momentum become absolutely insane.” – Michael Marcus, Market Wizard
Contrary to popular belief, it is good to tighten your stops when the market moves quickly in your direction.
Fast moving markets can rapidly reverse and chew though the profits you have made. It’s best to lock profits in and wait for a re-entry. Sometime this will mean that you miss out on a move as you get stopped out, but more often than not it will save your skin.
If you do get stopped out and reverse, you can use a re-entry strategy to get back in on the trend.
There are a few techniques you can use to retain your profits in a fast moving market.
- Tighten your stop to 0.5 – 1.5R
- Use a short term moving average such as the 3 period EMA displaced by 3 periods
- Go to a lower time-frame chart to manage the trade
- Look for a chart pattern reversal
Finding the right one (or combination) that fits you will take a little bit of live trading experience. You need to react quickly when you encounter this scenario, so be sure to use a rule that is congruent with your trading style.
Volatile fast moving markets moving against you
One of the more un-comfortable scenarios to face is when the market moves suddenly against you. This can happen when there is unexpected news, a global macro-event, or a sudden change in supply and demand.
If this happens, you have a couple of choices depending on your trading style and your view of the strength of the reason for the drop.
You could get out immediately and take the loss, or you could wait and hope that the position rebounds in your favour. This can be a very challenging decision to make, but, whatever you do, keep risk management at the top of your mind.
If you find yourself staying in a trade desperately hoping that it will recover, then you are probably best to cut your losses and exit the position. One compromise when faced with this scenario is to move your stop up tightly below the current price. If it recovers then you will benefit, but any further losses are strictly limited.
The price gets close to your profit objective and starts to fall away
An all too common occurrence for a trader is to have their trade going almost to the profit target, not quite hitting it, and then falling all the way down to the stop loss. This is the classic turning a winner into a loser trap.
Not only does this cost the trader profits, but it can be frustrating and psychologically damaging in the long run.
A remedy for this ill is to make sure your risk/reward ratio during a trade is never worse than 1:1.
For example if the currency price is 10 pips away from your profit target and your stop loss is 50 pips in the opposite direction, you would have a terrible risk reward of 1:5. That is, you are risking 50 pips in order to make an additional 10. In this case, you would tighten your stop to within 10 pips of the current price, dynamically re-establishing the 1:1 risk reward ratio.
This exit has the effect of tightening your stop once you get close to your profit target.
Chart pattern reversals
Often the charts act as a window into the soul of a trade. You will see that the price is about to reverse, and now is the time to act to protect your profits. But some reversals are not as strong as others, and you don’t want to be cutting your profits short by exiting on weak signals.
It will be tempting to close your trades early if you don’t have this aspect of your exit strategy down pat. If you do see a reversal and you are unsure if you should close your position or not, then you can always scale out or move your stop higher.
There are plenty of chart pattern reversals that can occur throughout the trade.
- Candlestick and bar patterns
- Classical chart pattern like flags, pennants, wedges
- Double tops and bottoms
The important thing is to know how to identify them and to have a plan on how to react to them when they do occur.
For shorter-term reversal patterns like candlesticks, you can wait for them to happen in combination with support or resistance levels. They could also serve as a sign to tighten you stop-loss rather than exit straight away. This will give you a little time to reassess and check that you have not made a mistake in identifying the chart pattern.
Fundamental or sentiment conditions change
If you experience a change in the news cycle from positive to negative it can be a good time to exit your position.
For example, if the market was ignoring bad news and continuing to push higher, then you would continue with the trade.
But if, all of a sudden, the market starts to sell off during bad news, then you know that something has changed either fundamentally or sentimentally, and it’s time to sell. Similarly, there could be a macro event or other news that could cause a change in the price movement of the currency pair you are trading.
If your assessment is that this is likely to continue, then you should close the trade.
Keeping is simple
For the newbie trader, this might seem like a lot of work, and it is. Therefore it is important to make it easy on yourself when you first start to define your complex exit strategy.
- Firstly, you should make some choices about what to do when the price hits your profit objective. I would suggest tightening the stop and looking to let the position run, or a simple profit target.
- Secondly, you want to have a maximum intra-trade drawdown stop. I would suggest you use a 3R stop, so that you will never let a trade go into a drawdown of greater than 3 times your initial risk after it is in profit.
- Thirdly, you will want a stop for fast moving markets. I would suggest that if you ever see the market rapidly take off in your favour, then implement a 0.5-1.5R trailing stop.
Next, you could investigate some stops based on chart pattern reversals. Candlestick patterns work well for identifying these reversals, particularly in combination with support and resistance.
Trade in the moment with the market
“Don’t think about what the market’s going to do; you have absolutely no control over that. Think about what you are going to do if it gets there” – William Eckhart, Market Wizard
By implementing a complex exit strategy, you will have the tools you need to be in the moment with the market and trade what is in-front of you. Putting together a set of exit rules is going to take some time, and that is ok.
You can start by applying the “keeping it simple” rules above.
Over time you can add in more rules as your market nous develops.
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Until next week.
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