By Jason Pearce
Exit Stage Right
So many traders spend the bulk of their time thinking about how to enter a trade, to the point of even obsessing over it.
Which fool-proof indicator will put them into the trade of the year?
What magical chart patterns are the keys to the kingdom of untold wealth?
How can one be positioned to rake in millions of dollars from the markets over the next few weeks?
For those seeking the Holy Grail on when to get into a trade, there’s a plethora of different books, websites, newsletters, trading gurus, etc. out there that are willing to accommodate paying customers.
But here’s the thing: It’s the novice traders who spend all their time and energy on finding that perfect entry signal. Professional traders don’t spend too much energy trying to perfect their entries.
After all, they know it’s not where you enter the market that determines your profit or loss on a trade; it’s where you exit the market.
Professional traders have a Stoic attitude towards the market. They believe that you cannot control the market; the only thing you can control is how you respond to the market. That means deciding when and where to get out after you get in.
To that end, let’s discuss a few methods that traders can use to exit a market.
Kill the Losers
The winning trades take care of themselves, but the losing trades have to constantly be managed. You can’t turn your back on them for a minute. As a matter of fact, a good synonym for a professional trader would be a risk manager.
Victor Sperandeo said that “the single most important reason that people lose money in the financial markets, is that they don’t cut their losses short.”
Before a trader even puts a position on, they need to figure out what the largest acceptable loss would be.
This is accomplished by determining where you to get out of a trade if it doesn’t work out as expected and placing the stop loss at that level, then implementing the correct position-sizing rule.
Once the position is entered, the trader’s primary job is to make sure that they stick to the initial exit plan.
After that, they can start to look for opportunities to reduce the risk on the trade through trailing stops, profit targets, rolling option hedges, etc.
Bad Stop Placement
There are a few ways to determine where to place the initial stop loss to bail you of a losing trade. One method that’s a popular rookie mistake is setting a dollar amount stop on a trade.
I’ve seen new commodity traders come in and buy a cocoa futures contract and say “place my sell stop $500 below my entry price”, which is the equivalent of 50 ticks on a 10-ton cocoa contract.
They then gets knocked out with a $500 loss before lunch…
And the market recovers by the close and proceeds to go even higher the next day!
The problem is that the $500 stop completely ignores the market’s current behavior.
What if cocoa is flip-flopping in a trading range of $800 a day for the last couple of weeks? Then that $500 stop loss acts more like an open invitation than an open order and has a high-probability loss of being filled.
A Better Way
A better way to determine the dollar amount for the risk-per-contract on a trade would be to measure the market’s volatility and use something bigger than that.
This method is not a guarantee, but it greatly lowers the probability of getting the stop hit by a silly random daily swing.
Suppose cocoa has had an average trading range of $800 a day for the last couple of weeks. The trader could use a protective stop of two to three times that amount instead of an arbitrary $500 dollar amount stop. In that case, the stop order would be $1,600 to $2,400 away from the entry price.
The Average True Range (ATR) comes in handy for measuring the volatility. It takes into account the difference between the daily highs and lows and, in the instance where the market has made a gap move, it measures from the prior day’s close to account for the gap.
To accommodate the wider stop and keep the risk size on the trade consistent, a trader simply buys less cocoa contracts.
Instead of buying five cocoa contracts and placing the sell stop $500 below the entry price, the trader might buy only one cocoa contract and place the sell stop $2,400 (three times the ATR) below the entry price.
Volatility is not the only way to set an initial stop loss. It can also be something as simple as placing sell stops just below price support at a prior low. Conversely, you would place protective buy stop orders on a short position above price resistance at a prior high.
In the case of a breakout move, initial protective stop orders can be set at the place where the breakout would be invalidated.
For instance, Nvidia Corporation (NVDA) had a couple of price peaks that marked price resistance back in December 2016 and February 2017 at $119.93 and $120.92.
If a trader bought on the breakout above these old highs in early May when the price reached $121.82, he could consider setting the initial stop loss order just under the $119.00 level.
The day that the breakout to $121.82 occurred, NVDA established the low for the day at $114.02. So perhaps a smarter approach for setting the sell stop order would be to place it just below $114.02 to give it more breathing room.
You need to keep in mind that you are not going to be the only trading setting their stops just beyond support or resistance. Everyone’s looking at the exact same chart as you.
That means the stops can sometimes get run and then market turns right back around.
So what do you do? Decide to not place a stop and just cross your fingers?
That’s certainly a bad idea. You’d be jumping out of the frying pan and into the fire. It only takes one really bad trade without a protective stop to wipe out your account.
There are a couple of possibilities for remedying this situation.
First, be prepared in advance to reenter the trade if you get stopped out and the market reverses.
I encourage you to create your rules for this reentry strategy in advance. You don’t want to be left on the sidelines and making an emotional decision in the heat of battle.
Second, consider setting the stop order beyond support or resistance by an amount that is meaningful. Perhaps something that’s at least bigger than the 20-day ATR. It could even be a multiple of it. That way, it will take more than just a random daily fluctuation to trigger your protective stops.
Going Out On Top
We’ve talked about a couple of ideas on where to exit a losing trade. But what about exiting a winning trade? That’s the next order of business.
To simplify it, there are really only two ways to exit a winning trade: Cashing out as soon as the market hits a pre-determined target or liquidating the position when the winner starts to give up some ground and moves against you.
I do want to point out that a trader can also use a combination of the two styles. Remember, trading doesn’t have to be a binary outcome where you are either “all in” or “all out”.
Many traders combine different levels of exposure and position sizes, so why not combine different exit criteria, too? Trading is not like the Yankees vs the Red Sox where you have to choose a side!
Some traders know where they want to take profits as soon as they get into a trade. Therefore, they will place limit orders to liquidate their position at a profit target if the market reaches it.
The advantage to this idea is that, if the market does meet your objective, you are not going to sit around and give back the profits that you’ve made on the trade.
A perfectly executed trade with this strategy is the one where the market reaches your maximum expectation so you can ring a bell and cash out at the top. You don’t care where the market goes after that; all you care about is that it hit your target.
Do It Right
There are different ways to set profit targets. First, let’s address what you should not do.
For the same reason that it doesn’t make sense to use a set dollar amount for setting a protective stop, it also makes no sense to use an arbitrarily set dollar amount for a profit target.
After all, if the cocoa market is normally making advances of $1,500, then why in the world would you want to cash at as soon as you have an arbitrary profit of something like $500?!
You’re almost guaranteed to leave a lot of money on the table when you trade this way.
The solution for the profit objective is the same as the solution for the protective stop: set the price objective based on the market’s volatility or exit when it reaches resistance/support at an old high or low.
If your market research shows that cocoa is making advances of $1,500, then selling out with a profit of just under $1,500 is congruent with what the market is doing. A successful trader tries to stay in sync with the market.
This also means that if the price volatility dies down and cocoa is only swinging around and making advances of $900, the profit targets would be scaled back from just under $1,500 to something a little less than $900. Otherwise, you may not get any of your profit objectives hit.
Markets are fluid so you must be ready to adapt and change with them.
Play the Range
This concept of trading the range is pretty obvious, so we won’t spend too much time on it. Simply put, the objective is to buy when a market nears the lower end of the range and sell when the market nears the upper end of the range.
This applies to both the entry and the exit on a trade.
Since markets seem to trade in congestion at least twice as often as they trade in a trending environment, don’t overlook this concept because of its simplicity.
I’ve seen range traders bag respectable amount of profits in trading ranges when the Buy & Hold crowd and the trend followers were either treading water or getting whipsawed. There’s definitely merit to this strategy.
That being said, you need to make sure that you have rules that tell you when a market is no longer in a trading range.
Once Elvis has left the building, so to speak, you need to abandon the market or have a different strategy to implement. Range trading is a mean reversion strategy. You better know how to tell when a market is in reversion mode and when it’s not (i.e. a trending market).
Harvesting Trend Profits
When the markets are in a trending mode, profit targets can still be implemented. But the difference between taking profits in a trading range and taking profits in a trending environment is that range-bound profit objectives should more or less be at similar levels while profit objectives in a market that’s trending should be at progressively higher levels in an uptrend and progressively lower levels in a down trend.
Bollinger Bands can be useful for setting profit objectives in a trending market. The Bollinger Bands plot a standard deviation (2 standard deviations is the popular choice) of a market above and below a market’s designated moving average.
When a market touches a Bollinger Band, it’s considered to be at a short-term extreme. Think of it as being similar to a rubber band that’s been stretched where the market should either snap back or else breakout.
To use this tool as a profit target, a trader would be long in a market that’s trending higher and then sell the position if/when it tags the upper Bollinger Band.
Once the market has pulled back some and perhaps tagged support at the moving average, the position would be reentered.
The inverse applies for a short position, of course. The trade would be liquidated if/when the market drops to the lower Bollinger Band and then re-shorted on a bounce back up to the moving average.
The drawback to using this Bollinger Band idea for bagging profits in a trending market is that there’s a good chance that a trader would miss out on some serious profits if the situation turns into a parabolic move.
You need to either be OK with being on the sidelines when things go parabolic or you need to develop some rules to get back in if it occurs.
Another useful strategy for determining profit objectives is to use an overbought/oversold oscillator. Presuming that a trader is positioned with the market trend, profits would be taken whenever the oscillator reaches and extreme reading.
Popular tools for measuring when a market is in overbought/oversold territory include the Relative Strength Index (RSI), Williams Percent R (%R), and the Directional Movement Index (DMI).
Just as the different types of moving averages (simple, exponential, displaced, etc.) generally end up showing the same thing on a chart, it seems that the different overbought/oversold oscillators usually end up in the same territory as well.
Also just like moving averages, overbought/oversold oscillators should be applicable on multiple timeframes. This is what makes it a robust tool that works just as well for the day trader as it does for the long-term trend follower.
Study the different nuances of each to see which makes the most sense to you. In the meantime, let’s look at an example of how one could be applied.
Williams % R
Long time trader and systems developer Larry Williams created this indicator that shows where a market’s closing price is relative to the price range between the high and low of a set time period.
In other words, the %R will show you if the market is in the upper end, lower end, or mid-part of the price range of the last X number of days, weeks, months, etc., indicating if it’s overbought, oversold, or neither.
The %R shows a range of 0 to -100. You can Google the math for the formula if you want it, but the important thing is to know that a market is considered to be overbought whenever the indicator reaches a level of -10 or higher and it is considered to be oversold whenever the indicator drops to a level of -90 or lower.
So how would a trader use it to take profits?
You exit a long position as soon as the %R hits the overbought level of -10 or higher and exit a short position as soon as the %R hits the oversold level of -90 or lower.
Once a profit has been booked, the trader can monitor the market and watch for a reentry setup to get back in after the %R is out of the overbought/oversold territory.
Beware: markets can hit oversold or overbought and stay that way for quite some time, especially when they’re in a fast moving environment. Exiting a long position when an oscillator hits overbought will then leave you on the sidelines while the market continues to run.
American financier Bernard Baruch once said, “I made my money by selling too soon.”
It obviously worked out OK for him…but can you live with getting out of a trade too early?
More to Come
We’ve covered a few ideas for exiting both losing and profitable trades. There are a lot more ways to skin the cat, though.
In the next post, we will discuss even more ideas that traders could incorporate into their exit strategies.
Make sure you put at least as much time –if not more- into designing your exits as you do your entries. It’s where you get out of a position that determines if you’ve made or lost money on the trade.
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- How To Exit Trades Part II - September 7, 2017
- How To Exit Trades Part I - August 31, 2017
- Building Pyramids for Asymmetric Trading Gains Part 2 - August 7, 2017