Closing the Trade - Trading with Strategy part 4

Sometimes traders do not really know when to close a transaction, and they keep on staying into a trade indefinitely until when they lose all their accumulated earnings. In order that this does not happen anymore, traders have to give themselves some rules, also because closing a trade is probably much more difficult than opening it. There are two schools of thought: some say that the targets can be forecasted or at least it is possible to have an idea about them, while others say that no one can know where prices are going and therefore it is virtually impossible to identify a target. Personally, we agree with the first theory, but I am going to try and analyze both them, as the management of the two approaches is very different.

There are established methods to estimate where prices will converge, methods based on the principles of the technical analysis. Here are some examples that can help in the estimation of these targets. Fibonacci extensions, Elliott waves and the price action are some examples.

For example, when you see a price break from an horizontal range, the projection of the amplitude of the same range might be a good target. The following graph shows us a concrete example. USDZAR between June and October 2012 has remained within a range of 8.06-8.48 (closing prices). At the time of the upward break, the bullish target has become 8.48+0.42=8.90, reached on October 8th.

USDZAR Trading Example

Another classic example is represented by the projection of a price movement generated by the formalization of a head and shoulder or a double top or bottom. Even in this case, a graph can be of help in order to fix our exit of the trade target. AudChf has formalized a short signal on February 22nd with the bearish break of the head and shoulder neck line. Our target will be represented by the range between the top of the head (0.9942) and the neck line (0.9711). The 231 pips are measured from the break point, so 0.9785. On February 24th the target of 0.9554 has been reached at the same point where the trade will have to be closed.

AUDCHF Trading Example

However, in all cases, the central point is that we open a trade with a possible target in mind and, theoretically, when prices reach that target, we should take the profit and then look for another opportunity.

Instead, when traders come to this point, they often begin to believe to be part of a wider trade and do not close the operation. It is precisely here that the most common mistakes occur. These mistakes can be avoided only by using built-in methods such as the manual adjustment of the stop loss and the use of the trailing stop. The following graph shows a typical case of manual adjustment of the 20 weeks moving average stop loss.

EURGBP Trading Example

Some traders are more confident to delegate the decision-making process of closing the trade to the computer instead of making it discretionary and therefore they rely on the trailing stop. The following image shows us the various possibilities that a typical broker (in this case Oanda) offers the trader to manage and close a trade.

Market Order Trailing Stop

The concept of the trailing stop is quite simple: when the price moves in the desired direction of "x" pips, the stop loss moves "y" pips. The parameters are customizable so we can establish that the stop loss of 10 pips moves automatically every time the prices rise up to 50 pips.

The trailing stops are used when we do not want to close a position at a definite target but we still hope in a continuous movement of prices in one direction. The trailing stop will move accordingly protecting our profits. The problem with this approach is that very often we are likely to be blocked by the volatile nature of the Forex market.

This is a valid strategy if combined to the previous discretionary one. The technique is known as "scale out" that is a mix between the two strategies, especially useful if, psychologically, we cannot bear to see the prices keep on running after the trade closure. After reaching the target, we close a part of the position and with the other one we can adapt the stop manually or with the trailing stop.

For example a classic method is to close the 50% of a profit position and leave the other part open with a trailing stop.

The graph shows the long trade currently in progress on AUDJPY where, after the closure of half the position, we have combined a trailing stop that increases our stop loss (coincident with the 20 days moving average ) of 21 pips daily.

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