The vital indicator most traders overlook

 

This week I want to talk about a type of indicator that most traders just overlook. They simply enter and exit trades without even looking at this important tool that can massively improve their reward-to-risk ratio.

It’s an exit indicator.

I often bang on about the importance of exits. Too many traders have multiple indicators and rules for their entries … and then a ‘let’s just let it run and see’ attitude to their exits. It’s completely the wrong way round.

I believe that exits are even more important than entries.

Therefore we should get some tools to help us make exits as good as they can be … and these are our exit indicators.

What an exit indicator can do

1. It’ll get you out of a winning trade at the best moment. By ‘best’ I’m not talking about the top of an uptrend of the bottom of a downtrend – trying to predict tops and bottoms is unreliable and likely to cost you more than it makes you. Instead we want to get out safely, often when markets start to hesitate, and before they reverse (potentially taking us out at a trailing stop).

2. It should be the primary method of exiting a losing trade – BEFORE your stop level is hit. By making your exit indicator the normal way to exit a losing trade, rather than the exception – you’ll see your reward-to-risk ratio significantly boosted.

3. It should also get you out of a stagnating trade that’s going nowhere. Time in the market is time when your capital is at risk. We  want to avoid spending unnecessary time in trades that just aren’t doing anything for us.

So, what should we use for our exit indicator?

The indictor that best gets you out of your trade will depend on the type of trading you do, but I’m going to offer up some suggestions for you to try.

First up … perhaps you already have this indicator on your chart. Does your entry indicator have an ‘off’ switch?

For example, if your entry requires a crossover, would a reverse crossover be suitable for an exit? Or perhaps your entry includes something like the supertrend indicator or the PSAR, which could flip the other way, indicating the trend is over.

Don’t force this – your entry indicator may well not be the best thing for an exit indicator. But it’s a good place to start looking.

The next place to look is momentum indicators [link]. We want to hop out of trades when the momentum has run out of steam, so an indicator that tells us momentum is dropping off can be a great way to get an early exit.

Here are three examples …

Relative Vigor Index

The RVI is a momentum oscillator based on the closing price, relative to the trading range. It consists of two smoothed out moving averages, and we can use a crossover of these lines as an exit signal that our move is flagging …

Stochastics

The Stochastics oscillator is very similar. My preferred way to use this indicator is by watching for divergence, which is a bit more involved that a simple crossover.

Like this …

MACD

The Macd is another momentum indicator, this time built from moving averages – this means it’s good for measuring the strength of a trend.

It can be used in much the same way as the RVI indicator, looking for crossovers against the trend.

I recommend that you check out this post which shows how you can adjust your MACD settings to make a very steady-handed exit indicator to suit your trading strategy.

Pulling it all together

I’m very aware of the dangers of overcomplicating our trading strategies with too many indicators. Indicators should be all about making our charts easier to read, not more complex.

If your exit indicator isn’t used for entries too, then don’t apply it to your chart until you’re into a trade – you just don’t need it. That’ll save cluttering up your charts with extra lines.

If you find your charts are getting too cluttered, consider which indicators are doing the heavy lifting – are some just replicating data you’re getting elsewhere?

And, of course, before adding an extra layer to your trading strategy, you must test, test, test. Run some back tests to see if it would have given you better results – if it does, then forward test too. (I’ll share with you my blueprint for how to run a bullet-proof trial very soon.)

Exit indicators really are a powerful way to boost the performance of any trading strategy. They can get the most out of our best trades, and cut losers short – it’s a win-win for profitability. I look forward to hearing which exit indicators work best for you.

 

 

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