3 Early Warning Signs That You Should Exit a Trade

Profits in the financial markets require multiple skills that can locate appropriate risk vehicles, enter positions at the right time, and manage them with wisdom and a strong stomach before finally taking an exit when opportunity cost turns adverse. Many investors, market timers and traders can perform the first three tasks admirably but fail miserably when it comes time to exit positions.

Getting out at the right time isn't difficult, but it does require close observation of price action, looking for clues that may predict a large-scale reversal or trend change. This is an easier chore for short-term traders than long-term investors who have been programmed to open positions and walk away – holding firm through long cycles of buying and selling pressure. (For more, see: Exit Strategies: A Key Look.)

While buy-and-hold strategies work, adding exit timing mechanisms can yield greater profits because they address the long-developing shift from open outcry and specialist matching to algorithmic software code that seeks out price levels forcing most investors and traders to give up and exit positions. This predatory influence is likely to grow in coming years, making long-term strategies more untenable.

Failing rallies and major reversals often generate early warning signs that, if heeded, can produce much stronger returns than waiting until technicals and fundamentals line up, pointing to a change in conditions.

Three red flags stand out as major wake-up calls to take a closer look that will often lead to a swift exit in order to preserve profits or avoid further damage.

Keep track of the average daily volume over 50 to 60 sessions and watch for trading days that post three times that volume or higher. These events mark good news when they occur in the direction of the position – whether long or short – and warning signs when they oppose the position. This is especially true if the adverse swing breaks a notable support or resistance level.

Uptrends need consistent buying pressure that can be observed as accumulation through on-balance volume (OBV) or another classic volume indicator. Downtrends need consistent selling pressure that can be observed as distribution. High-volume sessions that oppose position direction undermine accumulation-distribution patterns, often signaling the start of a profit-taking phase in an uptrend or value buying in a downtrend. (See also: How to Use Volume to Improve Your Trading.)

Also, watch out for climax days that can stop trends dead in their tracks. These sessions print at least three to five times average daily volume in wide-range price bars that extend to new highs in an uptrend and new lows in a downtrend. Further, the climax bar shows up at the end of an extended price swing, well after relative strength indicators hit extreme overbought (uptrend) or oversold (downtrend) levels.

Markets tend to trend just 15 percent to 20 percent of the time and are caught in trading ranges the other 80 percent to 85 percent of the time. Strong trends in both directions ease into trading ranges to consolidate recent price changes, to encourage profit taking and to lower volatility levels. This is all natural and a part of healthy trend development. However, a trading range becomes a top or bottom when it exits the range in the opposite direction of the prior trend swing.

Price action generates an early warning sign for a trend change when a trading range gives way to a breakout or breakdown as expected, but then quickly reverses, with price jumping back within range boundaries. These failed breakouts or breakdowns indicate that predatory algorithms are targeting investors in an uptrend and short sellers in a downtrend.

The safest strategy is to exit after a failed breakout or breakdown, taking the profit or loss, and re-entering if price exceeds the high of the breakout or low of the breakdown. The re-entry makes sense because the recovery indicates that the failure has been overcome and that the underlying trend can resume. More often, price will swing to the other side of the trading range after a failure and enter a sizable trend in the opposite direction. (See also: Trading Failed Breaks.)

Short-term (20-day exponential moving average, or EMA), intermediate (50-day EMA) and long-term (200-day EMA) moving averages allow instant analysis simply by looking at relationships between the three lines. Danger rises for long positions when the short-term moving average descends through the long-term moving average and for short sales when the short-term ascends through the long-term.

Price action also waves a red flag when the intermediate moving average changes slope from higher to sideways on long positions and lower to sideways on short sales. Don't stick around and wait for the long-term moving average to change slope because a market can go dead for months when it flatlines – undermining opportunity-cost. It also raises the odds for a trend change. (For more, see: How to Use a Moving Average to Buy Stocks.)

It's easy to find positions that match your fundamental or technical criteria, but taking a timely exit requires great skill in our current fast-moving electronic market environment. Address this task by being vigilant for these three red flags that warn of impending trend change or adverse conditions that can rob you of hard-earned profits. (For additional reading, check out: Simple and Effective Exit Trading Strategies.)