Exiting a Trade Beyond the Initial Stop

By Van K. Tharp, Ph.D.
When you design an exit for your system, one of the key things that you need to consider is the purpose behind that exit. In the second edition of Trade Your Way to Financial Freedom, I identified four possible purposes that you might have for such exits. These include each of the following:
Exits that produce a loss but reduce your initial risk
Exits that maximize your profits
Exits that keep you from giving back too much profit
And psychological exit
Rather than cover each of these different types of exits, I thought I’d focus on one particular goal and show you how to use exits to meet that goal. Let’s say your goal is to simply follow a trend as long as it lasts. However, you want to have a wide initial stop so you won’t be whipsawed once you get into the market. You also want to give the position plenty of room to move. And finally, you also want to capture as much of your profit as you can once you reach a 4R target. Notice how these objectives fit a particular set of beliefs about the market. Your system always has to conform to your beliefs about the market or you won’t be able to trade it.
So to meet your initial goal you need a wide stop. Let’s say you pick three times the volatility of the last 20 days as I described in the last tip. It gives you plenty of room to make sure that the random noise of the market will not take you out of your position.
Second, you want to give your position plenty of room to move as it is going up. Again, all you have to do here is trail your three times volatility stop to meet this objective. Thus, every time you make a new high, your stop will move up to trail from that point.
Third, once you’ve reached 4R, you don’t want to give much profit back. Thus, you decide that when your target is reached you will shrink your stop from 3 times the volatility to 1.6 times the volatility. It’s that simple. Your worse case, at this point is that the market would immediately retrace and you’d get stopped out. But your new stop is probably only about 0.5R now, so if you were stopped out immediately you’d still have about a 3.5R profit. But of course, the market could continue to climb and you are giving yourself a chance for a 10R profit or more.
Notice that all of these stops are simple. They all came out of my head, just by thinking about the types of stops that you might want to use to meet the stated objectives. No testing was involved, so they are not over optimized. No rocket science is involved. They are just logical and make sense for meeting the objectives. They are simple. Notice that you also have three different exits, but only one will be active at any one time – the one that is closest to the market price.
If you want to master exits for your trading system, then you must learn the different types of exits that are available to you. Notice what each one is designed to accomplish. And then when you decide how your system is supposed to work, you’ll find it easy to develop an exit that meets your goals.
Have a good weekend. Next week I’ll talk about how different people with different objectives and different systems can all make money even through they may be doing different things. This is Van Tharp.