Trading System: Sizing and Exit


The detail of position sizing was covered in the previous module on money management. The most important thing you can do is to preserve your trading capital, so plan that you do not put more than 10% of your account into any one financial security, and you do not risk losing more than 2% of your account. If you know how far down your stop loss will be placed, just divide your maximum loss by the stop loss size, and the answer will be the maximum number of shares to buy. For suggestions how to place your stop loss, just look at the next Exit section.

How to Know when its Time to Exit a Trade: Trading Exit Strategy


Where to exit may be the most difficult decision for inexperienced traders. You need to select a stop loss position which is appropriate to the type of trading you’re doing. If you trade short-term trends, the stop loss should be closer to your entry point than if you are trading medium trends, when a close stop loss might take you out of the trade too quickly. This applies not just to the initial stop loss position, but also to how closely a trailing stop, if you use one, follows the price.

How to close a trade that doesn’t go as planned -:

1. Placing a stop loss order with your provider will automatically exit a position that doesn’t perform as planned.
2. Time stop – consider putting a time limit to your trading positions whereupon if a trade doesn’t move in your anticipated direction, exit the trade. There is an opportunity cost in continuing to hold a security that isn’t moving (loss of potential opportunities) so there should be good reason to keep holding a trade for weeks, if not months!
3. If you’re trading short term, have a rule in place where if your planned objective target is not met in a specified amount of time, you will exit the trade.

Setting a defensive stop loss position is only half of your exit strategy, however, because many of your trades are going to make a profit and you should know when you enter the trade how you are going to exit if the trade works out. Writing out your exit strategy for either circumstance at the time you take the trade is the best policy.

Your system may define a stop loss level a certain distance below the support line, if you are trading with an entry triggered by the price retracing to support in expectation of a reversal. Your initial stop loss can be set by inspection of previous price action, if you can identify support levels. Your initial stop loss may be set just below the lowest low in the past three weeks. Or you can use the Average True Range (ATR), an indicator invented by Wilder, which gives a measure of the volatility of the price. Commonly, you may set the initial stop loss two times the ATR below the entry level. This should give room for the price to move normally without allowing too much loss of value before exiting the trade.

To exit when you have a winning trade, it’s quite common to use a trailing stop loss which will liquidate your position when there is a slight retracement in the trend and capture your profits. You should experiment with the distance it trails below the market price so that little glitches don’t take you out prematurely. You want the trailing stop to sell your position as quickly as possible if the price is falling, but only when the price has stopped going with the trend and started a retracement.

However, if you have designed a trading system to capture the range between a support and resistance line, you may instead decide to exit the trade when it is within a certain distance of the resistance, and not wait for the retracement. A trailing stop would be a good Plan B strategy, in case the price failed to go close enough to the resistance to trigger the exit.

While the above is not an exhaustive list of the strategies you can use, it summarizes many of the main ones. Building a trading system is not a five minute job, and the time you spend thinking about what you are going to do will be repaid many times when you’re actively trading. You shouldn’t try to over intellectualize the process, and it should make common sense to you so that you will have faith in the system even after some inevitable losses. Take time to put the rules you are going to use into words, and make sure it is unambiguous so that you are not caught having to make significant decisions when you are in the emotion of a trade.

Trading Tip – Place your stop loss at the same time of placing an order for the trade. Avoid using mental stops because even if you’re the most disciplined person in the world, anything can happen in the market and you need to protect your trading capital whenever you put it at risk.

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