Know way out: Have an exit plan

October 27, 2016 01:00 PM
There are a lot of choices a trader must make before entering futures markets.

There are a lot of choices a trader must make before entering futures markets. Some are obvious, like choosing a market, whether to base trades on fundamental or technical (or both) inputs and the size you will trade. At that point, a trader can go determine the best time and price to enter a trade. Once this well-thought out opening trade is executed, many traders mistakenly think the hardest part is over. But the exit plan is just as important, if not more important, than the entry. Traders should always have both sides of the trade in mind, when initiating a position. When creating an exit plan, there are multiple areas to focus on regardless of the market.  

The first and most obvious area to focus on is your risk-reward ratio. This is based on your stop level.   Placing a stop order can prevent major unforeseen losses, but should be based on market analyses within your comfort level. A traditional stop order is set at a particular price, and once the market trades that price, it becomes a market order. This means your fill price can often times be different than the stop price, so traders should work slippage into their risk metrics. However, it ultimately gets you out of the position based on your calculated personal risk parameters. It is important to have these orders put in place at the time of entry. Due to the fact that many futures markets trade 24/6, monitoring the markets at all times is next to impossible. 

This means your risk management is of utmost importance. At the same time, reward is extremely important as well. Setting your exit limit price order to capture gains can help to avoid having a winning trade turn into a loser. To protect yourself on both ends, a One-Cancels-Other (OCO) order can be very advantageous.  

Another order type to explore is a trail stop, which will consistently move with the price of the market. When a position moves strongly in your favor, you may want to let it run, but not risk all the gains you made. 

A trail stop allows you to keep the position open without risking all of your gains. 

The second, and often times completely disregarded, area to focus on is expiration. Outright futures contracts all have an expiration, whether they are cash or physically settled contracts. When establishing positions, it is extremely important to be aware of not only the expiration date, but the expiration time of that product as well. Futures products expire at all different dates and times. For example, the E-mini S&P futures quarterly expiration stops trading at 8:30 a.m. (CST) at the opening bell on the third Friday of that corresponding month. This in particular is a cash settled product, so your contract would officially expire out and close at the settlement price. On the other hand, physically settled products are most typically not carried up until the final trading expiration, due to delivery. 

In fact many brokerage firms don’t even allow delivery and require clients to exit on the last trade date. If traders do not exit their positions in these markets, they are often at the mercy of firm risk managers who do not have time to be concerned with a good fill price. For both of these products, cash and physical, each may be rolled into the next expiration month, therefore extending your position to the next expiration. 

This then leads to the third point to address, rolling your position at the proper time. When futures contracts come upon expiration periods, volume starts to flow into the next active front month contract. This is known to many floor traders as “the roll.” The roll typically starts about a week or so before the listed last trade date. It is important to keep an eye on thinning volume in your current contract month in order to appropriately roll your position to the next contract month.  By doing this, you are creating what’s called a calendar spread. This allows you to exit one contract month and enter into the next by selling one side and buying the other based on your current position.  

By executing this as a calendar spread, it reduces slippage and captures the best price differential on those two contract months. You will want to exit, or roll your position at the most liquid time. 

With every entry into the market, there needs to be an exit. A poor exit strategy can be detrimental to the success of the trade. It should not be an afterthought, rather, it should be considered at the moment of the execution. Whether that be in the form of working orders or alerts set on your trading platform, it is crucial to understand the importance of an exit plan.

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