During trading discussions traders often talk of which currency to get into, but rarely do they speak about how or when to exit. Exiting from a trade is arguably more important than the entry, as the exit is what determines the profit. By learning multiple methods for exiting a trade the trader positions them self for potentially locking in greater returns. There are several useful methods for exiting a position, all which are easy to execute and can be implemented into a trading plan. (Trading forex can make for a confusing time organizing your taxes. These simple steps will keep everything straight. See Forex Taxation Basics.)
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A stop-loss order is a very common way to control risk and exit a position if it reaches a point where we are unwilling to absorb further losses. If a trader purchases the EUR/USD at 1.3000 and places a stop-loss at 1.2950 it means the trader is willing to risk 50 pips (1.3000-1.2950) in order to potentially profit before that stop rate is hit. A stop-loss is placed at the time of trade, and figured out before hand.
There are potentially many methods for picking a stop-loss rate, but ultimately it must be at a place where the trader does not reasonably expect the market hit before putting the trader in a profitable position that warrants just reward for the potential risk taken.
The stop-loss order may be placed based on recent support or resistance levels. In Figure 1, if a trader decided to short the EUR/USD based on it breaking lower out of the range it was in (red down arrow), a stop-loss could have been placed just above the resistance level at 1.4590 (yellow line).
|Figure 1: EUR/USD, 30 Minute Chart|
A stop may also be placed based non-traditional support and resistance levels. These would include Fibonacci retracement levels or trendline support levels. In Figure 2 if a trader went long the AUD/CAD she could place a stop using Fibonacci levels based on the last large price swing the currency pair saw. Therefore a stop would be placed at the 61.8 level (rate=1.0327), which held off prior declines. Alternatively the trendline could be used as prices will likely find support at the trendline (also at 1.0327). If using a trendline for a stop-loss it is important to note that the rate will change over time as the line is sloping.
|Figure 2: AUD/CAD, 15 Minute Chart|
The use of the trendline as a stop-loss tool mentioned above is an example of a trailing stop. The stop will move closer to the entry point as the currency moves in the trader's direction. In other words, the trailing stop is dynamic and will change over time. A trader may also do this as new support and resistance levels are formed as the currency moves in their direction. The trailing stop attempts to lessen risk if the currency initially moves in a trader's direction but then fails to follow through. It also attempts to lock in a minimum amount of profit if the rate moves substantially enough for the trader to move the trailing stop to a profitable level. Trailing stops should only ever reduce risk, and should never be moved further away from the entry price (increasing risk).
Figure 3 shows how to implement a trailing stop using support and resistance levels. This is the trade from Figure 1 where the trader is short the EUR/USD near 1.4510 with a stop at 1.4590. The trade moves favourably, but then a rally occurs. When the rates move back below the former low, the downtrend is intact and the stop is dropped to just above the new resistance level, at 1.4450. The stop has "trailed" the price action and in this case has guaranteed a 60 pip profit as the trailing stop is now below the entry price.
|Figure 3: EUR/USD, 30 Minute Chart|
Dissolution of Entry Criteria
An often overlooked exit method is to simply exit a position when the original entry criteria no longer exists. This is especially useful when using technical indicator signals for entry. Take for example a trader whose method involves entering positions as volatility increases in an attempt to capture large quick moves. The trader may use an average true range (ATR) indicator to assess average volatility. In Figure 4 we see the AUD/CAD volatility climb as a sell-off begins. A trader takes a short position in anticipation of quick profits, which quickly come. Among many potential exits, a simple one is to simply exit when volatility begins to retract. After all, if volatility retracts the original premise for the trade, the trade should be exited.
|Figure 4: AUD/USD, 4 Hour Chart|
The timed exit is a relatively straightforward one. Prior to taking a position, the trader determines how long they would like to be in the trade. This may be based on personal reasons, such as time constraints or it may be more technical (and likely should be). Technically timed exits may include exiting at the end of the U.S. or European session. It may also use averages; for instance if a trader determines the average intra-day trend lasts four hours in a particular currency pair before reversing, the trader can use this as a time constraint on the position, exiting once four hours from the start of the trend has elapsed. Indicators such as Fibonacci time zones may be used, or if a news event is upcoming, the trader may wish to exit prior to the news announcement time. (We compare the results of two forex trades based on MACD histogram divergences. Refer to Trading Divergences In Forex.)
Finely tuned strategies require finely tuned exits. These may include a combination of all the methods mentioned prior, or may include specific exits for differing scenarios. Take for instance a strategy revolving around trading a major news announcement such as the Nonfarm Payroll (NFP) Report. In USD related pairs this announcement can cause large swings. A trader may wish to capitalize on a predicted currency pair movement once the report has been published. Following, the trader has no more need to actively hold the original pair as it was simply a play on the outcome of the report.
In the case of the NFP report (or any volatility causing news event) a trader may have a series of exits planned. One is the initial stop-loss - this is the maximum loss the trader is willing to take. The second is a trailing stop – as the rate moves in the trader's direction so does the stop. A third exit strategy may be to lock in profits if the situation develops where the trend could quickly reverse. Therefore, as a third exit a trader uses a candlestick pattern (for example) – if an engulfing or other strong reversal pattern occurs the trade is exited. In Figure 5 the NFP report was released at 8:30 AM (ET) on May 6, 2011, the news caused a spike in the USD/JPY. On the breakout a long trade is entered, with a stop-loss placed just below former support at 80.20. As the trade progresses a red bar occurs, but the rates moves higher once again. The stop is trailed up to this new support point. Several bars later a bearish engulfing pattern occurs (circled) and the trader takes the profits on that reversal signal.
|Figure 5: USD/JPY, 3 Minute Chart|
The Bottom Line
The combination of exit methods is virtually endless. While one trader may use only trailing stops, others may use a combination of a time, indicator, chart or candlestick patterns to aid in exiting. The ultimate goal is to keep profits and minimize risk. This can be done by using stop-loss orders, trailing stops, exiting when the entry criteria no longer exists, timed exits or strategy specific exits. By using these methods and possibly combining them, it may be possible to retain more profits and reduce losses. (Make more educated trading decisions by identifying major turning points. See Pivot Strategies: A Handy Tool For Forex Traders.)