Last Updated on 17 November, 2020 by Samuelsson
When many people think of trading, what comes to mind are the big profits and winning trades. However, as any experienced trader knows, losses are as natural in trading as winners.
In order to exit a trade in a rational and efficient way, it is paramount that you plan your exit before taking the trade. Doing so, you are less likely to let the pressures of being in a losing position drive you to make rash decisions that will hurt your trading performance.
In this article, we will have a look at some of the ways you can exit a losing trade, but we will also look at our attitude towards losing. However, before we cover ways to exit a trade, let’s just briefly discuss losses in trading.
Losses are Part of Trading
When we trade a trading strategy, we do so because we know that we have an edge in the market. By backtesting the strategy, we know that there is a certain probability that the next trade will be a winning one, given that the strategy is robust.
Even though the strategy might have 20%, 30%, 40%, or even 80% losing trades, we are ready to take the signal, because we know that either
A) the losing trades are much fewer than the winning trades
B) the winning trades are much fewer, but bring in much more profit than the losing trades.
The last option could certainly be emphasized further. There are many great systems out there, mainly trend following, that have a very low winning rate. However, when they finally get into a winning trade, those tend to offsets all previous losses and bring the equity back to positive again.
Every Trade is Random
To be able to make use of market edges and strategies, we must understand that we cannot control the outcome on the trade level. In fact, every trade on its own is random. It’s first when we look at a series of trades that we can start to determine the probability of a win or loss, respectively.
Even if you have a winning system, you really cannot tell whether the next trade is going to be a winning or losing one. This is important to understand since it has consequences for matters like position sizing, and expectations/trading psychology. A trader who understands that his next trade might be a loser will be less prone to risk too much, and suffer less from the psychological pressure of having to realize a loss!
How You Should Not Exit a Losing Trade
Before showing you how you should exit a trade why not go on to how you should NOT exit a trade. What we are going to discuss is a mistake that is made by many new traders, and while it might work for a while, it will eventually end in disaster!
So what is it?
Well, just don’t exit the trade if it’s a loss!
As strange as it might sound, some traders simply choose not to exit a losing trade. They believe that if they stay in the trade long enough, it will eventually turn around, and let them exit at a profit.
Using such a method assumes that the market is just in a temporary dip, and is soon to rebound. And while that assumption could hold true in strong bullish trends, it will eventually prove to be wrong. And once the market indeed turns around, those who applied this strategy will lose a large portion of their capital, if not all of it, that they’ve made from sticking to losing trades.
So how alluring the thought of holding on to losing trades even might sound, it’s bound to end in disaster, sooner or later.
However, even when it does work, it’s an unwise and useless method!
Why is that?
Well, the reason is not that complicated!
Efficient Use of Capital
When new traders start their venture, they seldom realize the importance of the time element. A portfolio that yields over 20% over the course of 2 months is impressive. However, making the same return over 10 years doesn’t even beat the market!
When traders lock in their capital in losing trades, they won’t be able to make efficient use of their capital. During the time that they waited for the trade to come back at breakeven, they have probably missed a handful of great trading opportunities, just because they didn’t want to accept a loss!
Locking in your capital in losing trades is by no means an efficient way of managing your capital. As a trader, you need to be able to cut your losses when proven wrong, and move on to the next setup!
Different Ways to Exit Losing a Losing Trade
Before you enter a trade, you should always have an exit strategy in place! Trying to manage a trade discretionarily in the midst of the psychological angst that comes from being in a losing position, is by no means a good idea. You need to have clear rules for how to manage losing trades, and ensure that you don’t deviate from them.
These rules should preferably be determined by running a backtest to find out what actually has worked in the past!
However, below we are listing some common methods that traders can use to know when to exit a trade.
1. Stop Loss
When discussing losses and losing trades, stop losses might be the first thing that comes to mind. You have probably heard that you never should trade a strategy without a stop loss. This is mostly true, and stop losses indeed are important tools to control risk. Still, there are some cases when they might not be optimal! We’ll cover that in just a bit!
For those who don’t know, a stop loss is an order that will get you out of the trade at a certain level. The stop level, which is the level that needs to be hit for you to be brought out of the trade, should be set with account size and the characteristics of the trading strategy in mind. As a rule of thumb, you want to make that you’re not risking more than 2% of your account on each trade!
You also want to set the stop level at a level that doesn’t interfere too much with the trading strategy. Setting a stop loss too close to the entry could seriously impede the performance of a strategy, and should be avoided. At the same time, you don’t want to set the stop loss too far away, since you’ll have to trade a smaller position to compensate for the added dollar risk.
Below you see an example of a stop loss. We entered a share trading at $200 dollars. Thus, our risk per share, which determines how many shares we can buy, is $20.
Dangers and Different Stop Loss Order Types
Even if you set a stop loss, you are not guaranteed to be exited at that price. Basically, there are two things that could happen:
1. The market might gap over the stop level, which renders the stop loss useless.
2. In illiquid markets, there is also a chance that there is no one to buy the security at the stop price, which will require you to go lower in order to have the position sold.
What happens in both these scenarios, depends on what type of stop loss you are using. Most commonly, traders choose between the two following stop order types:
- Stop loss order
- Stop limit order
Even though both aim to sell the security once the stop level is reached, they are quite different as to how they are executed.
Stop Loss Order
When the security reaches the stop level, a normal stop loss order sends out a market order. That means that we will accept to sell our positions at the nearest price that the market can support. In an illiquid market, that could mean that our exit price becomes lower than the set stop level since there were no buyers to take on our sell order. So we had to move lower in order to get the position sold.
In case the market gaps beyond our stop loss level, we will be exited immediately as the market opens the next day. For example, if the stop level was set at $20, and the market gaps to $15, we would get out at $15.
Stop limit Order
The other option, the stop-limit order, sends out a limit order if the stop level is reached.
A limit order is an instruction to buy at the limit price or better. For example, if the sell limit level is set to $20, that means that we are going to sell the security at $20 or higher.
In the case of stop-limit orders, the limit level must be lower than the stop level. Otherwise, the security won’t be sold, since a limit order is only executed at the limit price or better. While this puts at risk of not having the order executed if the price moves past the limit level, it also means that we have greater control over the trade. Perhaps we don’t want to give up the security at below the limit price!
Here is an image to demonstrate a stop-limit order. Both the stop level and limit level is marked.
In case the market gaps below the limit level, that means that we will not be exited from the trade. However, the limit order still is active in the market, and will be triggered if the market moves above the limit level again!
You might remember that we briefly touched on that there are some strategies where stop losses might not be appropriate to use. That true, but how do you know which strategies these are?
Well, the category of strategies we are talking about, are mean reversion strategies. With a mean-reverting system, we have an edge in that a market has moved excessively in one direction. This means that we also enter and take a contrarian position, at least to the short term trend.
What is important to realize with these strategies, is that the more a market goes down, the better our edge gets. So, if the market reaches our potential stop level, it means that our edge is greater than when we entered. In other words, a stop loss cuts us out of a trade that now is even better than when we decided to get in!
Of course, there is the aspect of having to know how much you risk, which could necessitate putting a stop loss. However, in our trading, we have solved this by keeping our mean reversion trading to a relatively small share of our portfolio. Once again, this is possible because of algorithmic trading!
If you want to learn more about stop losses, we recommend that you have a look at our guide to stop loss orders!
2. Trailing Stop Loss
Trailing stop losses simply are normal stop loss orders, but with one important difference. Instead of being set at a specific level, they trail the price. That way, if you happen to enter a trade that goes in your desired direction, at least in theory, you won’t be exited before the trend turns around.
However, in real conditions, this will seldom be the case. Markets are choppy and could easily run into your trailing stop only to continue climbing soon again. Still, trailing stop losses, if used right, are great tools for traders to maximize profits and limit losses.
You might wonder why trailing stop losses qualified to this list! Well, given that they lock in profits in a rising market, they make sure that a winning trade doesn’t turn into a losing trade if the price has moved beyond the trailing stop loss level. In the image below you see an example of what we mean by this.
The trailing stop rises with the market, and once it gets beyond our entry level, we know that the trade will be exited before it turns into a losing one!
In our trailing stop loss guide, we cover these type of stops in greater detail!
3. Time Exits
If you remember, at the beginning of the article, we talked about the importance of the time element in trading. If a trade doesn’t evolve in the direction you anticipated, you might want to exit the trade. That way you free capital that you can use to enter new trades with the probabilities more in your favor.
In order to set a time exit, you just set the maximum number of days/bars you want to remain in a trade. If any of the other exits don’t kick in before that, you’re brought out of the trade!
Time exits often also work good on their own, and many of our strategies rely on them for the main exit mechanism. In fact, they sometimes work remarkably well, given their simplicity!
Never disregard a concept in trading because it’s too simple! Many times the easiest and simplest conditions work the best! Time exits certainly are proof of that!
4. Support and Resistance
Some traders might choose to put their stop around a support or resistance level.
Support and resistance levels are levels in price that the security or market finds hard to break and that might act as support or resistance also going forward. Examples of support and resistance levels could be previous highs and lows, even numbers like 100, or a moving average. What matters is how the market has treated the level before. If a level has been tested several times and held, it generally is of higher significance.
When using a support or resistance level to exit a trade, you simply look for the levels, and place your stop loss slightly beyond them. The idea is that if the market breaks that level, you were proven wrong about the direction of the market and consequently exit the trade, albeit with a loss.
Here you can read more about support and resistance!
Knowing when to exit a trade is crucial if you want to keep your sanity in a position that goes against you. The psychological pressures that come from having to make the decision to exit a losing trade are hard to imagine if you haven’t been there yourself. And if the current trade goes against you after already having had a series of losses, that becomes even harder to manage.
It’s really hard to recommend one solution that applies to all strategies. Trading strategies vary by logic, market, and timeframe. As such, one exit method that works very well for one strategy, might be outright detrimental for another.
However, by reading this guide, we hope that you have gained an understanding of what it means to exit a trade, and what might cause troubles during the process!