Forex Trade Exit Strategies
11/04/2015 9:00 am EST
Probably the most challenging and frustrating part of trading forex is deciding when to close a trade. In this article, Adam Lemon, of DailyForex.com, explains why deciding how to close trades is so challenging and then outlines some useful methods to experiment with.
Many traders find that the hardest thing about trading forex successfully is deciding when to close a trade. This is known as trade exit strategy. It is probably the most challenging and frustrating part of trading and an area that tends to be overlooked in much forex education. In this article I am going to explain why deciding how to close trades is so challenging and then outlines some useful methods you can experiment with.
Why Are Trade Exits so Difficult?
There are two main reasons why trade exit strategies are so difficult.
The first reason is because many people think of them as the same as trade entries, just in reverse. The logic here is that a good long entry is the same as a good exit from a short trade. This is not really true, because we are usually looking for different things in our trade entries than we are in our exits.
For example, let’s say you have entered a trade because of a candlestick formation that you believe have some predictive power. The entry is successful and the price goes in your desired direction for the next five candles. You then see the same formation happen, but signaling a short entry. Is it correct to exit the trade now?
There is no right or wrong answer here that fits every trader, for the simple reason that you really have no idea whether the price will now reverse and hit your entry or stop loss, or will instead pull back a little before continuing in your desired direction by another two thousand pips.
The answer as to what is right for you depends upon whether you are aiming for profit from short-term movements or longer-term moves, or both. You have to answer this question yourself before you know what exit strategy is right for you. If you think you can win 60% of your trades and compound your risk to make a great return, it makes sense to be ready to take profits quickly. If you prefer the statistically easier but psychologically more challenging goal of winning only a few of your trades but making big profits from those winners, it makes more sense to be very patient before exiting trades. Of course, you can combine both outlooks and look to take partial profits early and leave the remainder on the table hoping for a big winner.
Now let’s turn to some good take profit and stop loss methods you can apply. These are all the methods you really need to worry about.
Fixed Reward to Risk Exit Targets
With this method, the distance from the trade entry to the stop loss represents 1 unit of risk. Here you set a take profit based upon a multiple of that until. For example, if you want 2:1, and your stop loss is 100 pips, you set a profit target of 200 pips.
Advantages: it is easy and can remove stress. If the pair is trending you can aim for a high ratio. You can also have several targets. If you are using a decent entry method and trading the hot currency pairs—and you use fairly high ratios of at least 3:1—you are giving yourself a good chance to achieve a profit.
Disadvantages: this method can be too rigid, as it takes no notice of how the market performs after entry. You might miss a target by just a few pips and end up losing the trade.
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This trade exit strategy is often overlooked. You simply decide you will exit any trade still open after a certain period of time. Back tests have shown this method to be surprisingly profitable. It has the same advantages and disadvantages of the previous method outlined above.
Reward to Risk and Time Combination Exit
You could combine the two methods discussed above by deciding for example to exit a trade at a particular future point in time if the reward target has reached at least a certain minimum.
Trailing Stop Loss
By trailing stop loss I mean either a real trailing stop loss which is set at a certain proportion or pip amount or any method that moves up the stop so you exit ultimately by being stopped out. Of these methods, either moving up the stop to be just below recent swing lows or chandelier trailing stops tend to get the best results.
These methods have the advantage of ensuring exits are based upon how the market performs. If you get a really strong move, these methods keep you in the trade for longer and help to maximize profit. The major disadvantage of these methods is that they might give up too much profit, especially if used incorrectly.
Support and Resistance
You could pick profit targets in advance based upon key strong support and resistance levels that you identify on longer-term charts and trade targets at these levels. The disadvantage with this approach is that these levels can be very unpredictable and whether they hold or not depends a lot upon what is happening with market sentiment and news. A better approach is to know where these levels are and keep them in mind for areas where it might be wise to exit if the price starts to turn around.
Trend Line Break
If your trade is in the direction of a clearly defined trend in which an obvious and unambiguous trend line can be drawn, a clear break of the trend line could be a good exit signal.
Double Top or Bottom
A more advanced trade exit strategy that takes practice to master—but which also tends to get good results while giving up relatively little profit—is to wait for a major high to be made (in a long trade), followed by a pullback, and then a failed attempt to break that high. This requires good judgment, but can be a great way of getting out of a trade with as much profit as possible.
The hardest part of this method is to know how to call the major highs and lows...and the failed retests. As a general rule, the longer the price takes to fail, the more decisive the failure is.
There are three types of double top or bottom:
- Classic, where the tops are roughly equal.
- Lower, where in a series of highs the first lower high is made or the first higher low in a series of lows.
- 2b Breakout, where a slightly higher price is actually made which then fails quickly.
Long-Term Technical Analysis
If you are making trade entries on shorter time frames, you might decide to be more optimistic and let winning trades run for longer based currencies that are trending strongly over the previous few months.
Fundamental analysis is not very good at telling you how to trade, but it can be useful in telling you which currency pairs might be more likely to move by many hundreds or even a few thousand pips over the coming weeks or months. Look not only at economic data but most importantly what the central banks in question are saying in their monthly statements, regarding whether they are seeing tighter or looser monetary policies as likely. Interest rates also have a small bearing, in that currencies with higher interest rates are slightly more likely to rise over the coming weeks than currencies with relatively low rates.
By Adam Lemon, Contributor, DailyForex.com