Selling is probably the most important thing you do in your trading life, yet it is the hardest thing to do. I don't know if it is an ego thing with traders or if they simply get too emotionally attached to their positions and this makes them unable to sell. But, I do know that the single biggest reason traders under perform is simply because they can't pull the trigger and move to the next issue. Money management is one of the most important aspects of trading. Many traders, for instance, enter a trade without any idea of what their exit strategy is. They are therefore more likely to take premature profits or, worse, let their losses run to the downside. Successful traders need to understand what exits are available to them and know how to create an exit strategy that will help minimize losses and lock in profits.
There are obviously two "endings" for traders: they take a loss or make a gain. When talking about exit strategies, we use the terms "take-profit" and "stop-loss" to refer to the kind of exit being made.
Stop-losses, or "stops," are instructions you can give to your broker to sell equities automatically at a certain point, or price. When this price is reached, the stop-loss will immediately be converted into a straight market order and sell. These can be helpful in minimizing losses if the market moves quickly against you. As well, if you are an active trader but have a full-time job, it behooves you to use this type of order for when you are away from the markets.
There are several rules that apply to all stop-loss orders:
- Stop-losses are always set above the current ask price on a buy (or buy-stop) or below the current bid price on a sell.
- NASDAQ stop-losses become a market order once the stock is quoted at the stop-loss price.
- AMEX and NYSE stop-losses enable you to have rights to the next sale on the market when the price trades at the stop price.
Further, there are three types of stop-loss orders:
- Good-till-cancelled - A good-till-cancelled (GTC) order is a limit order that stays on the books of the exchange-trading floor until executed or until cancelled by the investor. Many brokers, like Charles Schwab, will only hold the order for sixty days so be sure to check with your broker before you use a stop-loss.
- Day Order - The stop-loss expires after the current session is over.
- Trailing Stop - This stop-loss follows at a set percentage from the market price, but never moves downward.
Take-profit, or limit orders are similar to stop-losses in that they tell the brokerage house you want to sell at a specific price and not a penny less. Moreover, limit order points adhere to the same rules as stop-loss points in terms of execution in the NYSE, Nasdaq, and AMEX exchanges.
There are, however, two differences:
Developing an Exit Strategy
- There is no "trailing" point. If the stock goes up and hits your limit price, you're out.
- The exit point must be set above the current market price, instead of below.
There are three things that must be considered when developing an exit strategy. First, decide how long you are willing to be in the trade from a time standpoint. Is this going to be a swing trade (several days to weeks), a position trade (several weeks to several months), or some other length of time? Second, decide how much risk you are willing to take. If you trade using William O'Neill's CANSLIM method, you won't take any losses bigger than 7-8%. That is his risk tolerance. Third, decide your exit point to the upside. Where is overhead resistance? If the stock goes up, as I expect, where do I lock in profits?
How long am I planning on being in this trade?
The answer to this question depends on what type of trader you are. If you are in it for the long-term (i.e. several quarters to several years), then you should focus on the following:
- Setting profit targets to be hit in your time frame.
- Developing trailing stop-loss points that allow for profits to be locked in every so often in order to limit your downside or a significant reversal in the position. Often times, the primary goal of long-term investors is to conserve capital.
- Taking profit in increments over a period of time to reduce volatility while liquidating. Your sell decision does not have to be a 'sweaty palmed' all or none decision. You can use limits to reduce your position until you are completely out.
- Allowing for volatility so that you keep your trading costs down.
- Creating exit strategies based on fundamental factors geared towards the long-term.
On the flip side, if you are in a trade for the short-term, you should concern yourself with these factors:
How much risk am I willing to take?
- Setting profit targets that execute at opportune times to maximize profits. Here are some common technical execution points:
- Pivot points ? these are reversal junctures where the stock has previously "pivoted" in the opposite direction.
- Standard Resistance & Support levels.
- Trendline breaks ? These are a bit harder to predict but they will reveal themselves as the stock progresses in its current trend.
- Technical patterns ? Be aware of technical formations (i.e. head-and-shoulders tops, triangles, wedges, etc?).
- Developing solid stop-loss points which immediately get rid of holdings that don't perform.
- Creating exit strategies based on technical or fundamental factors affecting the short-term.
Risk is an important factor in trading. I typically tell new traders to be more focused on the risk side of the equation than the return side. When determining your downside, you are determining how much you can afford to lose. Often times, this will determine, in itself, how long you will be in the trade and where your stops will be. Those who want less risk set tighter stops; and those who assume more risk give more generous downward room.
Another important thing to do is to set your stop-loss points so that they are kept from being set off by normal market volatility. Beta (or Standard Deviation) can give you a good idea of how volatile the stock is relative to the market in general. If this number is within 0 and 2, then you will be safe with a stop-loss point at around 10-20% lower than where you bought. However, if the stock has a beta upwards of 3, you might want to consider setting a lower stop-loss, or finding an important level to rely on (such as a support level or a moving average.
Where do I want to get out?
Why would you want to set a take-profit point, where you sell when your stock is performing well? If you don't treat your trades as "nameless companies", you run the risk of getting emotionally attached to your positions and hold equities when the underlying fundamentals of the trade have changed. On the flip side, traders sometimes worry and sell their holdings well before the trade should be closed, even when there has been no change in underlying fundamentals. Both of these situations can lead to losses and missed profit opportunities. Setting a point at which you will sell lends discipline and takes the emotion out of trading.
The exit point itself should be set wisely. For long-term investors, this is often at a fundamental milestone, such as the company's yearly earnings announcement. For short-term traders, this is most often set at technical points such as certain resistance levels, pivot points or pattern exhaustions.
Exit strategies and other money management techniques can greatly enhance your trading. Most investors, especially new ones, tend to focus on how much they can make and don't consider the risk of the trade. In reality, risk should be the focus of any investment and not returns. Before you enter a trade, consider the three questions we discussed and set a point at which you will sell for a loss, and a point at which you will sell for a gain. In the end, this risk/reward scenario will help you pass on trades that don't offer enough upside per unit of risk and will also firm the most important aspect of your trading; your discipline.