Stops are an important weapon in most traders' arsenals, and a good exit strategy will keep a trader from losing too much on a trade or giving too much back after a trade moves in to profit.

Though I agree that every trader should have an exit strategy prior to entering a trade, I've often struggled with determining which of the myriad of strategies is the best approach.  Which strategy will maximize my profits and minimize my losses, while at the same time not stop me out before my trade really takes off?

Here's what I've come up with over the years...

Initial Stop

Part of planning my trade before I ever place the order is determining where my initial stop will be placed.  In fact, the distance between my entry and my stop determines how large my order will be, so I don't know how many units I can buy or sell until I know where my stop will be.  I like to place my initial stop just below the recent swing low when I'm going long or just above the recent swing high when going short.  There are two reasons for this:

1. I place my trades in the direction of the prevailing trend when the market is making higher highs and higher lows or lower lows and lower highs.  If price takes out a prior swing high/low, I will no longer have a reason for being in the trade.
2. Placing my initial stopped based on a prior swing high/low takes volatility of the instrument I'm trading into account.  If I were to use a fixed pip amount for my initial stop, on the other hand, it may be too close or too far for the current market conditions.  A 100 pip stop, for example, which might have been suitable for the EUR/USD a year ago, is too close for times of increased volatility like we've seen this past month.

Breakeven Stop

As soon as my trade moves in to profit by a reasonable amount, I like to move my initial stop to breakeven.  This allows me to, as the old adage goes, "Never let my winners turn into losers."  By moving my stop to breakeven, my trade essentially becomes risk-free and I can let it run for as long it wants to move in the right direction.

Trailing Stop

If I haven't been stopped out yet and my trade continues to move in my direction, I'll start to periodically move my stop to lock in profits.  I've never been fond of using profit targets to exit my trades - I know some traders use them with great success, but they don't fit my personality - so I like to use trailing stops as my profit-taking exit strategy and let the market take me out when it's ready to turn.  I haven't, however, completely settled on the type of trailing stop I prefer, so usually I'll open a position and exit half of it based on the first of the following two methods, and exit the other half based on the second:

1. Trailing Stop Based on Price Action -When the instrument I'm trading makes a minor pullback (that doesn't stop me out) and then resumes its trend, I adjust my stop to just below/above the recent pullback.  I like to keep my trailing stop below/above the most recent pullback for the same reasons that I place my initial stop just below/above the recent swing.  If the market turns against me and takes out my stop, my reason for being in the trade is no longer there, I take my profits and move on to looking for the next setup.  This method works great in a market that is consistently making higher highs and higher lows (or LHs and LLs) in an orderly fashion.
2. Fixed Amount Trailing Stop - When the instrument I'm trading makes a new high (or low), I adjust my new stop to be the distance of my initial stop below (or above) the new high (or low).  This type of trailing stop generally locks in pips faster, but has a higher risk of stopping me out early before the trend has reversed, leaving pips on the table.  On the other hand, if the trend is not strong or nearing its end, this strategy can make some pips where the former trailing stop strategy might not.

I think both of these trailing stop methods are sound strategies, and time will tell which one is better or if they are better used in conjunction, as is currently my practice (using the first method for half of my position, and the second method for the other half).  I work full-time on weekdays, and the platform that I use does not offer trailing stops, so I adjust my stops manually a couple of times during the day (usually once in the morning, once around lunch-time, and once in the evening).

Update 1/6/09 3:06 PM:  Regarding trailing stops, I've abandoned the use of a "fixed amount trailing stop" and have been using a "trailing stop based on price action" exclusively once my trade is profitable and I've closed my first half at 1R.  In addition to the methods of exiting a trade presented in the original post above, I occasionally go ahead and exit the second half of my trade if I get a clear signal in the opposite direction of my position, even if my trailing stop is a ways away.