Exit strategy is actually the predefined rule or plan for closing the open positions while they are in profit. Exit strategy is more important than an entry strategy but very few traders realize this. Ultimately it is the exit strategy that defines if you are in profit or loss. Exit strategy is also known as Take Profit. Technical analysts and successful traders know the importance of exit strategy and thus they always follow their exit strategy. As successful traders are disciplined traders, thus they do not violet their exit strategy.
Exit strategy varies trader to trader. Successful traders choose their exit strategy carefully and try their best to make their exit strategy suitable with their trading style, goal etc. Before setting an exit strategy, you should know yourself and your trading strategy well. Otherwise, you would face hard time to find a suitable exit strategy for your trading strategy. A complete trading strategy or trading system must have a well-defined exit strategy. Otherwise, their trading strategy would be incomplete.
There are three different types of exit strategies. Fixed exit, trailing stop, dynamic or indicator based exit.
In this type of exit strategy traders generally decide a fixed percentage of profit target such as 10%, 20% etc. For example if you bought a stock at $10 and you are aiming 20% profit then your profit target level is at $12. Major advantage of this type of exit strategy is, you don’t have to lose from your profit or you don’t have to sell when the stock is in falling mode. A major disadvantage is, you might lose big profits if stocks move further after your exit.
Trailing stop is one kind of stop order that can be placed at a defined percentage away from a stock’s current market price. In case of a long position, trailing stop is set below the security’s current market price. In case of a short position, trailing stop is set above the price. A trailing stop protects the profits by enabling a trade to remain open and continue to profit as long as the price is moving in the favorable direction, but closes the trade if the price changes its direction by a significant percentage.
Dynamic or Indicator Based Exit:
This type of exit signal is more frequently used by trend following traders. Like trailing stop this type of exit strategy can protect profit. Traders generally use reversal signals of indicators as an exit signal. Choosing indicator for dynamic exit strategy depends on his trading strategy. Generally trades use same indicator for both entry and exit signal. For example, buy stock when MACD shows a bullish crossover or buy signal and sell it when MACD shows a bearish crossover or sell signal.
Daily chart of F (given below) is showing buy and sell signals of MACD indicator. Here sell signals are exit signals for long positions:
Exit strategy should match with the trading strategy, entry signal, trading goals etc. Traders should also back-test exit strategy before using it in real or live trading. It is better to use same indicator for both entry and exit signals.