Forex Exit Strategy

Forex exit strategies are a very important part of forex trading systems.

In fact, it could be said, that out of all the components of a trading system, it's the exit strategy and the money management rules of a system that are the most important to help make a system profitable and have an acceptable drawdown.

Let's firstly get an overall picture of what are the variosu types of exit strategies that are used together in a forex system. And then we'll go through a real life trade to show you these strategies in action! This is the best way to learn about how they work and why they're there.

So firstly, realise that there are 5 important forex exit strategies:

1. When you’re in a position, you usually have an initial stop, which may or may not be the same as your trailing stop, depending on the system that you’re trading. The purpose of the initial stop is to get you out of the trade, if the trade goes against the direction of the trade early on in the trade. It therefore serves to limit your losses. The initial stop is usually closer to the entry price than the trailing stop, and thus is the one used, until the trailing stop comes through it.

2. A breakeven stop may also be used. This is where your trailing stop loss is moved to the breakeven point (the price where if you exit, will be equal to your entry price). This stop, if present, serves to protect profits. This is especially true during volatile markets where currency prices may fluctuate enough to get you out too frequently at your trailing stop, if a breakeven stop is not used.

3. You may also have a take profit stop. This is when you exit the full position or half the position, when a target profit of “x” number of pips, or some other criteria if the trading system has been reached. Many systems use a take profits stop as they're more profitable with a take profit stop as well as a trailing stop, instead of just having a trailing stop. This would have been determined during backtesting or forward testing of the system.

4. The trailing stop, as a part of your forex exit strategy, is a stop that moves in the direction of the trade, which is up for a long trade and down for a short trade. An ideal stop is one that allows enough "room to move" and hence allows the profits to run, and of course eventually gets you out when the trade does turn against you.

5. Finally, a trade may be exited before a major economic announcement, because during such an announcement, there may be a temporary but very large increase in volatility that may cause you to be stopped out at your trailing stop.

So really, there are 5 common types of stops in all: initial, trailing, breakeven, take profit stops, and stops due to fundamental events in the market such as announcements

Let’s have a look at these stops in more detail.

We'll do this by having a look at real life trade on the GBPUSD.

A short entry was signalled at 1.7640 (point "a”), and the initial stop loss was 1.7658 (point “b”):

In this system, the initial stop loss is the same as the trailing stop loss, and is determined by peaks and troughs. In a short trade, as it is in this example, the trailing stop is placed a certain number of pips above the occurrence of a peak, as we have seen at point “b”.

Note that the way you’d work out when a peak or trough has occurred will depend on your system. For this example, just know for now that the price action defined a peak at the high of the candle marked point “b”.

In this system, as mentioned the trailing stop is used as the initial stop. But let’s say for a moment that we did have an initial stop at say 1.7648, which is lower than the trailing stop. If this was the case, then the initial stop applies, and the trailing stop is irrelevant at this point in time, as the initial stop will be hit first if the price rises. In fact, the trailing stop would be irrelevant until it is lower than the initial stop.

So what happens as the trade progresses?

Firstly note that as new troughs are formed, that trailing stops are typically never moved backwards. That is, for this short position, they’re moved down as lower peaks are formed, but not back up if higher peaks are formed. You’ll see this soon.

Next, if your system has a breakeven stop, then when the currency reaches the breakeven price, your trailing stop is moved to this price. Then from this point onwards, your trailing stop would stay here until lower peaks are formed below this breakeven price, causing the trailing stop to be moved lower once more. There’s no breakeven stop in this system.

Now, what does happen in this trade, is that the profit target of 30 pips is reached, and according to the systems rules, half of the total position is closed at the chart price of 1.7605, at point “c”:

The half position is actually transacted at 1.7610 (1.7605 plus spread) as it is a buy order, hence the 30 pips profit on half the position (1.7640 - 1.7410 = 30 pips).

Now, after you’ve done this, you’d only have half of the face value remaining, so you’d simply have to then adjust your stop loss to cover half of the original face value, instead of the full original face value.

A variation of this, is that instead of exiting half at that point, you’d have a trailing stop for half your position at that profit target price, and a trailing stop for the other half at where the trailing stop normally is.

The trade continues, and the trailing stop is adjusted down to point “d” and then beyond to "e", "f" and "g"...

Remember the trailing stop is not moved back up (in a short position), because this means that the trailing stop is going in the wrong direction.

Finally, as the price action reverses and breaks through your trailing stop at point "i", you’re exited from the position at the " exit candle":

This trade in fact made 30 pips on the first half, and 90 pips on the second half. Not bad at all, especially since it only took only 2½ hours.

So there you have it, you’ve just learnt the intricacies of the various types of forex stops in a forex trade :)

If you’re new to forex, these may be new concepts for you. But if you grasped the above, then you have grasped some valuable concepts and skills in forex trading. It will also help you to learn new forex systems a lot faster.

Well done!