Last updated on February 11th, 2020
Whenever you take a trade, you should be looking to profit from certain market behavior:
- a reaction to a level
- market momentum
- break out
- trailing your stop looking for bigger gains.
Prices set the limits of our risk and potential profits, but at what point does the market behavior no longer fit with what you hope to see if the trade still has the potential to be a winner?
At what point does the trade become invalid regardless of what price the market is trading at and is time to anticipate an exit from the market?
If the market isn’t doing what your trade theory anticipated, how long do you hold on to the position before you bail out?
Knowing when to exit your trade when the adverse price action begins to eat your profits is vital for your bottom line.
Know What To Expect In A Trade
Take a situation where you’ve sold the market based on potential downside momentum which you expected to come into play with the break of a key support level. However, although the market hasn’t taken you out yet and doesn’t even look like doing so, trading has gone flat and the expected momentum is nowhere to be seen.
What’s your next move going to be?
Are you going to sit there and wait for something to happen or are you going to decide to get out of the position as the original premise for the trade is no longer valid?
You’ve seen this sort of situation before too – sometimes you get out early only to see the train leave without you, other times you refuse to miss the trading opportunity and you end up paying for it. You need to give the trade some room to breathe, but how long is too long to stick with a trade which isn’t acting as you hoped?
What Does Your Trading Strategy Back Test Tell You?
The issue is that the length of time in a trade for your strategy might have a impact of the win:loss ratio or it might have no bearing at all.
It could be that there are telltale signs that a trade isn’t going to work which are independent of time or it could be that time is the all important factor. So it’s a good idea to back-test your strategy to see whether there are any correlations at all.
If you have the data for trades you’ve already taken, then study that too.
If there’s no correlation, you can feel confident in sitting in your trade for as long as it takes to take you out for a win or a loss. But if there is, then it’s definitely worth your while to take this into consideration.
Of course it could be the case that for what you consider to be a long time to be in trade, there are too few trades to draw any reliable conclusions from. Identifying whether there are any triggers which make trades less likely to be winners is slightly more involved, but well worth your while.
An indicator or perhaps a certain type of bar might give you early warning. If you test the occurrence of this (for both winning and losing trades) and it reveals itself to be a reliable signal, you have something you can work with.
What Signal Will You Use To Determine A Failed Trade?
If you do find that there’s some sort of signal indicating that an early exit might be sensible, there are some clear reasons to do so apart from the obvious.
From a psychological perspective, you can start getting into bad habits that will affect your trading success going forward. You can end up sticking with the trade and taking a winner, but for the wrong reasons.
It might have been better to exit the trade you have but because a new setup in the same direction then occurs, you get away with it. This can reinforce staying in trades too long when your data suggests it’s bad to do so.
If you take a loser when you’ve been starting to feel uneasy about the trade, it wouldn’t be unusual to beat yourself up over it. But I’m of the opinion that the biggest potential issue is that while you’re clinging to a trade that’s going nowhere, this there may be other, better opportunities which you end up missing in either direction.
If you’ve taken responsibility for the situation and have done the research, you can relax in the knowledge that you are being pro-active in your decision making whatever the outcome of an individual trade – remember that wins and losses come in a random distribution.
How Will You Exit?
There’s more to it than just identifying that the trade might not work. If you have some sort of signal (time or otherwise) then how are you going to exit?
- Will it simply be an at market exit?
- Will you tighten your stop to a closer reference point?
- Will you alter your position sizing to take into account the additional risk and also give yourself the opportunity to re-add to the position if the situation changes?
Timing in trading is not simply about knowing when to take a position, but it’s also about knowing when it’s right to exit too.
Getting out of a position can often be more subtle than always taking a winner to target or a loser to stop. Reading the market’s intentions by its behavior can alert you to changes before price moves allowing you to make proactive decisions in the correct circumstances.
Pattern Failures – Your Clues To Early Exits?
Let’s imagine for a moment that you take two types of trade entries: You trade pullbacks and breakouts. Knowing what to look for to get you out before your stop loss gets hit can save you a full 1R loss because the setup pattern is no longer valid.
If I trade pullbacks, I need to see an impulse leg that shows market intent. When price pulls back, this is the opportunity to enter but what happens next is just as important.
The bars in this graphic have pushed up showing some momentum to the upside. A lazy pullback happens with a standard reversal type candlestick and buy stop is placed above the high.
What we would now expect, if we are looking for continued momentum to the upside, is price to begin to stage a move.
- Instead of price heading to the upside, we see price form a trading range. This is not something we want to see considering we are playing for another impulse move to the upside. This may be a point where you tighten your stop or take all risk out of the market via an exit
- In this section, assume price continued to the upside after the buy stop order was triggered. We get a healthy push up, a reversal candlestick forms, and price slams hard against us. This is not conducive to another impulse leg and the wise choice is probably to exit the trade.
For your homework, consider breakout trading and what helps build the case for a sustained breakout and price moving in your direction – in other words, what should the resolution of a breakout look like?
Next up is to do the opposite. What would a breakout like this that has the potential to fail look like?
By doing this type of work, you can save yourself from taking full stop outs because you know what you are looking for with a successful pattern resolution.