Four Consistent Ways to Take Profits When Trading (Exit Strategies)
Most day and swing traders spend more time planning and contemplating entries than exits. While proper entries are important, most seasoned traders agree that trading success relies on how a trader exits their trades.
Which of these exit methods to use is ultimately up to you, based on which ones result in the best performance for your account. I use three of these methods, depending on the trade and market conditions. Compare the different techniques in a demo account, or look at your past trades and see if one method would have produced much better results than the others. Obviously, you want to go with the one that works best for you. Using any of the methods means you will be implementing the same approach each time you exit a trade, which translates to more consistent performance because you won’t be second-guessing yourself and wondering if it is time to take profits or not.
Pre-Determined Reward:Risk ExitCopy link to section
One of the most successful ways, based on my trading experience, for determining exit points is to look at the reward:risk ratio of any trade. Applying a reward:risk ratio ensures well calibrated and pre-set exit points. If the trade doesn’t provide a favorable reward:risk, the trade is avoided, which helps eliminate low-quality trades from being taken. If the target (the “reward” portion of the trade) is reached on a trade, then the position is closed at the target price according to the strategy. If the stop loss is reached (the “risk” portion of the trade) then the manageable loss is accepted, and the trade is closed before the loss gets worse. There is no confusion on what to do: exit as planned, at the predetermined exit points, whether profitable or unprofitable.
In my own trading, I like to have at least a 1.5:1 reward:risk for day trading, and a greater than 2:1 reward:risk when swing trading. This is the minimum recommended. It’s possible to find setups with ratios of 5:1, or even higher. That means that for every dollar you risk you stand to make five. I determine the reward:risk for each trade before I take it, based on the strength of the trend and how far the price is likely to move in my favor (for additional reading on how to analyze trends, see Trading Impulsive and Corrective Waves).
If the using a basic 2:1 formula, then a stop loss placed 100 pips (if forex trading) from the entry point means the target (reward) must be at least 200 pips away from the entry point. With the reward:risk established, and orders set, the trader can sit back and let the trade run until one of these levels is reached and the trade is closed. The chart below provides an example of the reward:risk exit in action.
The chart above represents a typical trend trade. The trend is up and I am buying during a pullback. I often wait for the price to consolidate (blue box) for several bars and then buy when the price moves above the high of the consolidation. In this case, the difference between the entry and my stop loss (placed just below the low of the consolidation) is 16 pips. We can see that even if the price only runs to the prior high, or even if it didn’t make it there, it is still possible to have a decent trade because we could have taken profits at 2:1, 3:1 or even 4:1 reward to risk ratios. All of which represent a good return on the risk we were taking.
The reward:risk model is simple and effective, in theory. The challenge comes in making it all work together. For example, the target still needs to be a placed where it is likely to be reached. It doesn’t matter how good the reward:risk is if the price is unlikely to ever reach the profit target. A good target, with a favorable reward:risk, also requires a good entry technique. The entry and stop loss determine the risk part of the equation, so the smaller that risk is–but not soo small that the stop loss gets triggered unnecessarily–the easier is to have a favorable reward:risk.
Sound confusing? Assume you are swing trading and buy a stock at a $50, placing a stop loss at $49. You are risking $1, and even if you placed a target at $53 to $55, that is a pretty reasonable expectation. The price only needs to move 10% to reach $55 (or 2% to hit the stop loss), for a 5:1 reward to risk. Many $50 stocks can move 10% quite easily within a week or two. But, if you buy at $50, and place a stop loss at $45, your risk is $5. Now you need to place a target at $60 or $65 (a 30% move) just to get a 2:1 or 3:1 reward to risk. A much bigger move is required to reach the target. Assume you risk $200 on both these trades. With the first trade, you can much more easily make $600 to $1000 on a conservative upward move. With the latter trade, the price needs to make a big jump just to make $400 or $600 (see Proper Position Sizing for an explanation of how this works).
Let’s look at my forex trade above again, but this time let’s assume I got a much worse entry and used the same stop loss location.
The risk is now 38 pips, so just to get a 2:1 reward:risk I need to put my target 76 pips above my entry. Oops. As we can see, that ended up being too ambitious. The price may eventually make its way up to my target, but I could be in this trade for a long time…and for a small profit. Also, the price rallied in my direction but then pulled back and is trading near the entry point once again. For comparison, on my better entry (chart prior), I could already be out of this trade, have collected my bigger profit, and be looking for other trades.
We want to keep our stop loss (distance from entry) as small as possible, but still out of the way of minor fluctuations, as this will allow us the best chance of taking high reward:risk trades where the target is still likely to get hit.
The name of the game is to find setups that produce high reward:risk ratios, yet only require relatively conservative price moves to produce those ratios.
Multiple Targets and Risk Reduction ExitCopy link to section
Another way to exit a trade is to use multiple targets, and reduce the risk as the targets are reached. Assume a trader opens a position by selling two lots of the EUR/USD. They place a target at 75 pips for the first lot, and a target of 150 pips for the second lot. A stop loss is placed at 30 pips on this particular trade. These are sample figures with the actual numbers varying from trade to trade.
If the price moves 75 pips in our favor, close out half the position at the first target. Then, move the stop loss on the second lot to break even. Even if the price drops to our the stop loss while still holding the second lot, no money is lost and we still have the 75 pips we made on the first lot. If the price continues to move in our favor, then we make 150 pips on the second lot. By staggering our targets we make more (if both targets are hit) than if we just used the 75 pip target for both lots; and by adjusting our stop loss to breakeven after the first target is reached, we reduce our risk and are assured a profit (from the first portion that hit our first target).
This method can be expanded to three targets, or four. Exit 1/3 or 1/4 of the position, respectively, at each target. As each target is reached, move the stop loss to breakeven, then the first target, then the second, then the third.
With this method, we are taking profits as the price moves favorably, but we are also reducing our risk as this occurs because the stop loss moves to the prior target once a new target is filled.
The multiple targets method is easily combined with the reward:risk method described above. In the reward:risk method we picked one target. That works very well if you have practiced and are skilled at picking targets that both maximize profit and are likely to get hit. This isn’t always easy though. Therefore, another option is to exit a portion of the trade at various reward:risk ratios.
Assume you short sell the EURUSD at 1.1510, and place a stop loss at 1.1520. You’re risking 10 pips. Place targets in 10 pip increments below your entry. The first target is 1.1500, then 1.1490, then 1.1480. A third of the position is exited at each of these targets, representing reward to risk ratios of 1:1, 2:1, and 3:1, respectively. This is a simple example, and you may opt to only place targets at 2:1 and 4:1, or 1:1, 3:1 and 6:1.
There are no right or wrongs, rather it is about making the method work for us based on how we trade. With this approach, you may also wish to move your stop loss as targets are reached. When the first target is reached, move the stop loss to the entry. When the second target is hit, move the stop loss to the first target, and so on.
Trailing Stop LossCopy link to section
A trailing stop loss is when we move our exit point to lock in profit (or reduce a potential loss) as the price moves favorably. For example, you buy a stock at $50 with a stop loss at $49. When the stock goes to $51, the stop loss moves up to $50. Once a stop loss has been moved up, don’t drop it back down again. If the price keeps rising to $52 the stop loss goes to $51. The price may keep rising, but will eventually pullback enough to hit the stop loss. This is a simple example, and you were already introduced to this concept in the section above.
Trailing stop losses can be quite dynamic though, incorporating statistics or technical indicators. Average True Range (ATR) is a calculation that looks at how far an asset typically moves over the course of one period, on average. That period may be 1-minute, 10-minutes, 1 hour, 1 week….whatever timeframe you have on your chart.
For example, if looking at a daily chart we may see that a forex pair typically moves 50 pips in a day. If we are in a swing trade, on any given day the price could rally or decline, but over time we expect the price to keep moving in the trending direction. Therefore, if we expect the price to go down, we may place a stop loss at 3xATR above our entry price. This means that the price would basically have to rise the equivalent of three days worth of movement to hit our stop loss. That gives our trade lots of room to start moving in our anticipated direction.
The stop loss stays where it is until the price starts dropping like we expect (if going short). This is when we start to implement a trailing stop loss, always keeping the stop loss 3xATR above the current price. Since we are in a short trade, we can only move our stop loss down, never back up. So if the price rises or ATR increases, our stop loss stays where it is.
Keeping track of all this is a pain, but luckily there are indicators that do all the calculations for us. One of my favorite versions of the indicator is called ATR Stops, available on TradingView.com (free real-time charts…although I do pay a yearly subscription to get rid of the ads and have more functionality).
The indicator only requires we input two settings: Period and Multiplier. The Period is how many price bars we want the average of for our ATR calculation. A period between 5 and 14 is standard. I typically use 6 periods with this indicator. For my trading style I find it works the best, although for your trading style you may find another Period setting works a bit better.
The chart below shows this in play. In this case, the settings are 6-Period and a Multiplier of 3.5. I determined the Multiplier setting by looking at the prior rally (rallies) for the asset I am interested in. I find the lowest ATR multiplier that would have kept me in the last rally (even though I wasn’t actually in it) until there was a significant pullback. That gives me a good idea of what settings I need to use for this stock when I do I find a trade setup. In the case below there were two potential entries: a pullback-consolidation breakout and a rounded bottom entry.
Note: settings are a bit different for each stock, forex pair, or futures contract because every one has different volatility. But my Period setting is almost always 6 and my Multiplier setting is almost always somewhere between 2.7 and 3.7. While the settings window is open you can adjust your Multiplier by 0.1 at a time and see the effect.
How to Use the Trailing Stop Loss IndicatorCopy link to section
The indicator is below the price, following it up, when the price is rising. When the price falls below the indicator, the line flips above the price following it down as the price falls. Since I like to buy during pullbacks in uptrends (or short during little rallies in downtrends), sometimes the indicator will still be above the price (showing red) when I buy. That is okay. This indicator is not meant to give entry signals, only exit signals. At the time of my trade I still place a stop loss…typically just below the most recent swing low. If the indicator is already below your entry point at the time of a purchase, you can use the indicator as your stop loss level.
If you are long, start using the trailing stop loss once the indicator is below the price. If you are short, start using the trailing stop loss once the indicator is above the price.
The indicator moves with each price bar, so you always know where your exit is before the price reaches it. One option is to exit as soon as the price touches the indicator.
Alternatively, wait for a price bar to close below the indicator line, if in a long trade. Then move your stop loss to just below the low of that price bar. Since I like to trade trends, this gives the price a little more room to start moving in the trending direction again. If you look closely at the chart above, you will see that the price touched the indicator line multiple times on the rally higher…any one of these “touches” could have closed my trade if I opted to use that approach. But no price bars closed below the indicator line and then kept dropping…so I am still in the trade and making more profit. Which approach you opt to use is up to you. There are pros and cons to both.
Do not judge the indicator by how it acts when you are aren’t, or wouldn’t be, in trades. For example, I am mostly a trend trader, and I prefer to focus on strong trends when swing trading. Therefore, I only care about how the indicator performs after a valid trade setup in a strong trending stock. During times when an asset is not trending strongly the indicator will not perform well, as discussed below. That is okay, though, because I am typically not in trades at those choppy times.
And remember, if you are waiting for the price bar to close outside the indicator, just because the indicator flips to red to green (or vice versa) doesn’t necessarily mean you are stopped out. In the chart below the price reverses from an uptrend into a downtrend. Once the downtrend has started I am looking for an entry signal to go short. A signal occurs when the price drops below the small box I have drawn. At the time of the trade, the indicator is below the price. That is fine. I will still go short and place my original stop loss. Once the indicator flips back above the price and I will start using the indicator as a trailing stop loss.
Once the price starts falling, it eventually closes above the indicator line again. We drop our stop loss to just above the high of this bar. On the next bar, the price keeps falling so we are not stopped out. Later on, the price closes above the indicator again. Our stop loss is moved again, in the same fashion. A few bars later the price hits the stop loss and gets us out of the trade, having captured a nice downside move.
At the time this trade was taken, the trend is was not particularly strong. I would call this a “normal” trend. Therefore, I actually I wouldn’t have used a trailing stop loss, rather I would have used the reward:risk method and looked to get in and out a couple of times during this downward move. But the example does illustrate how this particular trailing stop loss method works. Feel free to adjust it to your liking.
Other Trailing Stop Loss IndicatorsCopy link to section
There are many ways to implement a trailing stop loss, and some indicators may help in this regard.
Some examples of other indicators that could be used as trailing stop loss are Turtle Channels and Envelopes, Bollinger Bands or Keltner Channels, TTM Trend, or even a humble Moving Average.
The trailing stop loss can also be based on price action. For example, you sell a currency pair at 1.2510 and place a stop loss at 1.2525. You are risking 15 pips and trading off of a 5-minute chart. You don’t place any profit targets, but once the price has moved more than 30 pips in your favor (2:1), you start dropping your stop loss to just above the most recent high of every new price bar. As long as each bar keeps dropping, your stop loss drops to lock in more profit. As soon as the price moves above the high of the last bar, you are stopped out and collect your profit. This is just an example, but shows how you can create your own trailing stop loss method.
Pros and Cons of Trailing Stop LossesCopy link to section
I only use trailing stop losses on trades where there is a strong trend. A strong uptrend is when each upward price wave moves well above the last swing high. A strong downtrend is when each downward price wave moves well below the prior swing low. For comparison, in normal uptrends, the price moves a little bit above a prior high before pulling back. In weak uptrends, the price is barely making new highs before pulling back.
During strong trends, the price can move a lot further than we think. The trailing stop loss keeps us in the trade as long as the price is moving well. During choppier conditions, or when the price is in a normal trend, I don’t use a trailing stop loss because it will not work well. Instead, I use the reward:risk method. Before the trade is taken I determine which exit method I will be using, then I stick with it.
So that is the tradeoff: trailing stop losses work well, but usually only in strong trends. The reward:risk method works well all the time, but during very strong trends it is highly likely you will be leaving money on the table. Trying to use a trailing stop loss in choppy conditions–or in weak, or even normal, trends–will likely lead to poor performance…or at least worse performance than if using a properly implemented reward:risk method.
Time-Based ExitCopy link to section
A time-based exit is used in conjunction with other exit methods, and will supersede them in some cases. A time-based exit allows us to close a trade before our target or stop loss is reached, but only under certain conditions. Day traders don’t typically hold overnight positions, so it’s prudent to close all trades, regardless of profit or loss, by the end of the trading day…or whenever the trader decides to quit for the day.
Another time-based exit is to close all positions a couple minutes before a major economic news release (like interest rate announcements). Most day traders and some swing traders do this, and then resume trading after the announcement.
I personally opt to close all my day trades before news announcements. About two minutes before, I just hit the close button on my day trades regardless of profit or loss. Once the news is released, I go back to trading again. On shorter-term swing trades, I also typically close my positions before a major news (for forex) or earnings releases (for stocks). For longer-term trades (like my forex weekly charts method), I leave my trades open and am not concerned about closing them prior to earnings or news releases.
Establish any time constraints you opt to work within, then stick to the rules that you set. Use time-based exits in conjunction with the other exit methods.
Final Thoughts on Taking Profits When TradingCopy link to section
I primarily stick to reward:risk and trailing stop loss exits. For many of my trades, I use the reward:risk (one target) method because I know exactly what I am getting and am happy to risk a certain amount to potentially make more. I use a trailing stop loss only when an asset is in a strong trend. During strong trends the price can run for much longer than I expect. Therefore, I extract more profit by letting it run as far as it wants, then getting out when it starts to pull back and triggers my trailing stop loss. For normal trends, that aren’t exceptionally strong, I find that a well-placed target extracts more profit than the trailing stop loss. That said, placing high-probability targets takes a lot of practice, whereas using a trailing stop loss does not. Find the method that works best for you then stick with it.
Time-based exits make sure we don’t get stuck in a situation we don’t want to be in, such as holding a day trading stock after-hours when liquidity dries up, or holding a position through a major news event that could cause us to lose much more than expected. Longer-term traders don’t need to worry about this as much, but should still be planning their exits using one of the other methods.
Finally, another exit method is to place multiple targets, taking profits as the price moves favorably. This strategy can be a bit easier to implement than picking one target, because we can just place targets at various reward:risk ratios instead of trying to pick one. For example, place a target at a 2:1 reward:risk, another at 3:1, 4:1, etc. The stop loss can also be moved to reduce risk as the targets are reached.
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