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BRIAN HOOPS

By Staff | Nov 12, 2010

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 6 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 an order that when a pre determined price is 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.

PSYCHOLOGY

How many times have you been in a trade and taken a profit only to see the market roar significantly further in the direction of your original position? How many times have you held onto a position for what looked like a significant move developing, only to see your nice paper profit disappear and perhaps turn into a loss?

Of course if you have traded for any length of time you have experienced both of these situations. How do you avoid them? One of the keys to having the discipline to stay in the game is to make peace with the fact that you simply cannot avoid them.

I try to remember these three points while in a trade:

  • The market can go anywhere. There are things less likely, but virtually nothing is impossible. Don’t get caught thinking the market can’t go any lower or higher, because in those cases it usually does.
  • Remember that what happened in the last trade is of little significance to the current trade you are in. In fact, it may actually have an inverse relationship. Do not change your exit plan based on the meaninglessly small sample size of your last trade and or last few trades.
  • The large majority of the time short term day traders, or swing traders who are in for a few days, are going to be more successful by taking profits while the market is going your way. Pay yourself!

SUMMARY

In conclusion we should continue to give high billing to exits in the quest to be better traders. Entries are what we might do or could do, but exits are what we have to do.

Many entry techniques can work very well with just the basic exit techniques I have described herein. Most important of all, however is to remember the three rules of exits.

If you can stick by these rules, while the market is doing its best to get you to break them, then you are a big leg up on the ladder of successful trading.

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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