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By Staff | Dec 11, 2009

Most of the work done in technical analysis is concerned with how to find new trades and how to get on board once a trade setup has been identified. Considerably less literature is devoted to the topic of getting out of trades.

This article will discuss stop loss exits, profit targets, trailing stops, as well as intertwine some psychological aspects to be aware of while in a trade and/or looking to exit a trade.

Stop loss

I’ll start off with stop loss orders. It is often quoted that something like 90 percent of all new traders are out of the game within the first six months of starting. The reason for this elimination from the game is rarely because these new traders are lousy at picking the direction of the market they are trading.

Rather the overwhelming reason these traders get wiped out is because they trade without a stop loss. A stop loss order is a pre determined price taht, if hit, triggers an order to exit the existing position at the market.

There are many ways to determine stop loss points. You will find that different techniques are best suited for different markets. One of the most basic strategies is to place stops just under previous low points (if long) or just above previous high points (if short).

After running thousands of historical tests on various trading strategies I can say that this is a decent stop loss exit strategy to use in most markets. If you are doing your own system development and testing you might want to consider adding a wrinkle where the stop loss is displaced somewhat from the previous high or previous low. I have found that a plain stop price, such as “n” number of tics through the previous high or low, is the best way to handle this.

Dollar stop

Another basic stop loss to use is the dollar stop. This means never risk more than “x” dollars on any trade.

This is good as a fail-safe stop to include in a strategy for those infrequent occasions when your other stop loss techniques might be unreasonably far away. This is a stop loss that shouldn’t be hit very often, but is only there to avoid a disaster.

One stop loss technique that you may not have come across as readily as the previous examples, is to base the stop loss point on the highest high (for long trades), or lowest low (for short trades), since the trade was entered.

For example, when long I identify the highest high made in the trade and use the low of that day as my stop loss. Unlike a stop loss that is based on the lowest low of the last “n” days, the stop based on the highest high is static until there is another new high. Depending on the strategy being employed one might also run a stop loss using the lowest low of the highest high day plus “n” number of days preceding it.

Breakeven stops

The breakeven stop is a popular stop point. This is when the market moves in your favor and you move the stop to breakeven (entry point), often done in conjunction with an exit on some portion of a multiple lot position.

This strategy sounds good in theory and can work in practice, depending on the exits used for that initial position.

Remember though, that many of your wins will be on a partial position and almost all of your losses will be on a full position. Generally I do not move my stop to breakeven because it is often too tight of a stop.

Overall my experience leads me to be a fan of moving the stop as a trade becomes profitable, but not moving it all the way to breakeven.

With regard to multiple lot positions and different exits, you should realize that with each different exit you are trading distinctly different strategies. As such, each entry/exit pair must stand on its own as a profitable trading strategy. That usually means you’ll need to achieve some minimum threshold as a first profit target in order for

the strategy to stand on its own. Hence while the concept of “covering transaction costs” on the first contract of a multiple lot, may sound good in theory, it rarely passes the proof test when asked to perform as a stand alone strategy.

The last point I want to make about stops is not to make them too tight. If you do, most assuredly you will run into a series of losses greater than if using the exact same entry method with a wider stop loss. I often cut the stop loss to 50% of the original amount once a trade starts to go my way. By moving the stop to a smaller amount, but not to breakeven, yields the best results for most strategies I have tested.

Trailing stops versus profit targets

My experience indicates that using profit targets is better then using trailing stops. Trailing stops are okay as an additional exit when employed along with the profit target, but they should not be employed instead of the profit target.

Now someone is surely thinking about the old market adage “cut your losses and let the winners run”. To an extent it is true. You do need to control losses, but do not use too tight a stop. You do need to let winners run some, but make sure there is a profit target. These views are not my subjective opinion, but the results of thousands and thousands of tests I have run on hundreds of different trading strategies.

Brian Hoops is president and senior market analyst of Midwest Market Solutions Inc. Midwest Market Solutions is a full-service commodity brokerage and marketing advisory service, clearing through R.J. O’Brien.

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