Talking Points:
- Getting great exits is crucial for a successful trading strategy
- Understanding money management
- Learning how to setup exits in 3 different ways: traditional stop/limit, moving average trailing stop, and volatility based stop/limit.
Through emails, phone calls, and tweets many traders I work with
on a daily basis are quick to point out why they are entering a trade
and are able to describe each setup in great detail. But something I see
much less of are traders talking about their exit plans.
Most prudent traders will setup a stop and a limit to go along
with their trade, but I’d venture to guess most traders are spending a
lion’s share of their time on worrying about getting good entries. This
would mean they setup their exit strategy as an afterthought which as a
trading instructor, concerns me.
Our exits should be just as well thought out as our entries and we
need to have clear reasons on where we exit our trades and under what
conditions. Without an exit strategy, we are taking on a lot more risk
than we should be.
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Exit Strategy #1 – Traditional Stop/Limit (Using Support & Resistance)
The traditional stop/limit method is one that I use constantly
during my simple trading strategy webinars. I like it because it is both
versatile and effective. The goal is setting our stop and limit so that
they have a positive risk to reward ratio and are set around support
and resistance levels. Let's take a look at an example of a short Euro trade against the USD that occurred a couple weeks back on a daily RSI chart.
Learn Forex: Traditional Stop/Limit Based on Support & Resistance
When selling a pair, we want to look back at the previous bars and
look for an obvious swing high. That swing high could potentially act
as a resistance level in the future, so we would like to set our stop
loss several pips above that level. This way, the only way we are taken
out of the trade is if the pair has enough strength to make a new high.
This is fine because if a pair is showing that much strength, it's not a
pair that we want to be selling anymore anyway.
Next, the limit order we place will be 100% dependent on our stop
loss’ distance. Using the ruler tool on our chart, we should figure out
how far our stop loss is set in pips. In this example, our stop is 100
pips from our entry price. We should set our limit twice as far as our
stop. That is 200 pips in this example. This is will give us a 1:2 risk
to reward ratio.
The next exit strategy is an interesting one for many, because it includes trading automation.
Exit Strategy #2 – Moving Average Trailing Stop
It has long been known that a moving average can be an effective
tool to filter what direction a currency pair has trended. The basic
idea is that we only look for buying opportunities when the price is
above a moving average and we only look for selling opportunities when
the price is below a moving average. But some traders have found that it
can be effective to use a moving average as a stop loss.
The idea is that if a MA is crossed from one side to the other,
then the trend is shifting. If we were trend traders, we would want to
close out our positions once this shift has occurred. So this is why
setting your stop loss based on a moving average could be effective.
In the example below, we are looking at a M15 chart of the USDJPY
which is currently in an uptrend based on the 100 period exponential
moving average. At the time when I opened this long position, I placed
our stop loss directly at the 100 EMA level. This put our stop loss
about 80 pips away. Wanting to stay true to our 1:2 risk to reward ratio
rule, I set my limit at 160 pips.
Learn Forex: Stop Loss Based on 100-Period Moving Average
As the trade develops, the exponential moving average is going to
change with each new candle that is created every 15 minutes. As the EMA
moves, we will update our stop loss to match the 100 EMA. You can see
that from the time I opened the trade until now, the 100 EMA has risen
30 pips, raising our stop loss 30 pips alongside it. This means almost
40% of the risk we were taking on our trade originally is now gone. But
you will notice, our limit stays fixed at the amount of pips it was
originally set to. This means our risk to reward ratio improves
throughout the life of the trade.
Obviously I know many of the Forex traders reading this do not
have the time to manually change their stop loss every time their chart
prints a new candle, so I am including free download links to automated
strategies that will automatically adjust your stop loss in real time to
match the MA of your choosing. As long as your platform remains open
and connected to trade servers, your stop will continue to move until
the trade is closed.
Exit Strategy #3 – Volatility Based Stop & Limit
I’ve saved the easiest exit strategy for last. This final
technique uses the ATR (Average True Range). The ATR is designed to
measure market volatility. By taking the average range between High-Low
prices for the last 14 candles, it tells you how erratic the market is
behaving and this can be used to set your stop and your limit for each
trade.
The greater the ATR is on a given pair, the wider your stop should
be. This makes sense because a tight stop on a volatile pair could get
stopped out too early. Also, if we set our stop too wide for a slow
moving pair, we might be taking on a larger risk than we really ought
to.
In the chart below we used an ATR Pips indicator.
I recommend setting your stop loss at least 100% of ATR. In the
example below, we set our stop loss at 43 pips. Following our 1:2 risk
to reward ratio, we set our limit twice as far, 86 pips.
Learn Forex: Stop Loss & Limit Based on Volatility (ATR)
The ATR Pips indicator will adapt to any time frame you throw at
it, so it is completely universal. Simply set your stop at 100% ATR, and
set your limit twice that amount. Once the stop and limit is set, it
will stay at those levels throughout the life of the trade. You are not
required to move your stop and limit as ATR changes.
Ending With a Bang
Remember that forex trading is more than just getting good
entries; your exits should be just as important. You should always have a
game plan before you open any position and I hope the 3 exit strategies
in this article will help you develop a winning system or help improve
upon an existing system.
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