Exiting trades early is controversial. Some purists believe you must stick with trades till they die naturally – either by stopping out or reaching the take profit level. The reasons they cite: strategy integrity, hit rates, performance measurement, are all well and good, but all traders eventually come across a situation where they want to exit a trade ‘in an unplanned fashion’. The causes can be as simple as making a mistake, or adverse economic events, or they could stem from noticing parts of the technical picture that only became clear once the trade goes live. In any case, when you find yourself in this situation you need to be able to make a decision – should I stick with this trade, even if I feel very sure it will be stopped out, or exit early? Timing this decision, and finding the most effective way to do it, is an important skill, and one that takes practice.
Situations where you should exit trades
As mentioned above, some traders advocate never leaving trades early: we will get onto this in a second. Assuming we accept it is sometimes permissable to leave a trade, it is a good idea to work out when this might be. Some initiative is always required, but a non-exhaustive list of potential reasons is below:
External events, be they geopolitical, natural, or economic, can cause traders to rotate out of positions in a hurry. Wars, earthquakes, flooding and so on can cause sudden, unpredictable moves in the currencies of affected economies, partially because so many traders look to cover or leave their long positions. If you hold a long position in a currency that is experiencing one of these events, especially if it looks set to have a prolonged impact on their economic output, it might be worth closing the trade early.
This is related to the broader issue of ‘trading the news’, or adjusting positions according to the financial calendar. Generally it is a good idea to prepare any hedges or position reductions before the announcement is made if there is any concern about negative impacts. An example could be GDP number announcements in an economy that has been the subject of recent negative news, it may be worth exiting any long trades before the announcement. The principle here is that you expect increased volatility, volatility that negates the original technical reason for the trade.
Lets say you entered a long trade in a range bound pair as it bounced off a lower support band. You set a take profit level at the resistance level, which the pair initially approached, before falling away and beginning a downtrend. Currently the trade is profitable, but should the downtrend continue, you may be stopped out just below the entry point. Many traders would consider taking profit early and accepting the reduced return to avoid this risk. This type of early trade exit is much more controversial, for reasons we will discover shortly.
Problems with early exits
The first two justifications for an early exit are fairly uncontroversial – it is not an indictment of your strategy if an earthquake causes your long currency to suffer losses. Fundamental traders make their profits based on negotiating the sort of economic announcements found in the second category, and may well try and ride through them, but strictly technical traders prefer to avoid these conditions. The real problems lie with the last group, early exits for technical reasons.
Experienced technical traders form strategies based on rules, and expect to win a certain percentage of their trades over the long term. Good risk management practices are essential here – if you have a 50/50 risk / reward ratio, you will require more than half of your trades to win. A common practice is to have a take profit level twice as far from the entry point as the stop loss, meaning a strategy with just 25% winning trades will be profitable.
The problem here is that your win rate is affected by any early exits. When you exit a trade early, you are essentially dragging down your take profit level in order to improve your win rate. This is a trading psychology failure, where the desire to be right, to win your trade, outweighs the risk management strategy you started out with. A strategy with a take profit of 10 pips and stop losses set at 1000 would likely win 95%+ of the time – it would still be unprofitable. When you bring down your take profit level by exiting early, you alter your win rate but also your risk / reward ratio. This weakens the overall strategy and makes it much harder to record your real performance.
We have established the problem with exiting trades early – it deviates from your strategy, making performance measurement impossible and unwittingly leading you into a non-functioning strategy. Sometimes however, the temptation to alter trade parameters is just too great, and fortunately there is a solution: adjusting the stop loss. When you move down the take profit level, the risk / reward ratio becomes ‘worse’. But if you move up the stop loss instead, you can protect the risk profile of the trade, while still stopping out if the trade moves against you.
Very frequently, traders will ‘adjust stops to zero profit’, that is bring them up to the entry point of the trade. It is also possible to bring the stop loss to a positive profit point, guaranteeing some return however the markets continue to develop. That way you will still record the trade as stopped out, and it will not interfere with measures of strategy success nor with the risk profile, but you will be protected from further losses. An alternative method to achieve the same result is to hedge the trade by buying put options, though this strategy is best reserved to experienced traders, comfortable with complex derivatives.
In conclusion, traders must be aware that losing trades form an integral part of their overall strategy. A continuous run of losing trades, or trades continually just falling short of take profit levels or any other problem should be addressed with a considered change of strategy, not the reactive early closing of positions. Ultimately traders must understand their role as one of managing risk – we are paid a premium for taking on certain risks, in the same way a banker earns interest on a loan. Whether or not we are ‘good traders’ depends on our ability to identify the correct premium for the right level of risk, and closing trades early unbalances this progress.
The most successful traders follow strict formulae, always updating them to respond to external conditions and their own performance, but not interrupting them out of emotions such as fear. One way of improving your trade discipline is to keep a journal – in it you can record concerns about exiting trades early or external conditions, and this will give you a full record of past conditions you can refer back to. In general, except in the limited conditions described above, traders should not close deals early.
How Rakuten can help
Exiting trades early is always tempting – no-one likes to lose trades. But traders must always be aware whether they are leaving a trade because of a real change in external conditions, or whether they are simply gaming their strategy, and trashing the risk / reward ratio in the process. As always, practice makes perfect, so why not open a free demo account today?