Exiting the Trade

Part I - The Purpose of Trading

So you've gotten into a trade. Now what?

The purpose of this article is not to show you how to enter the trade. There are dozens of strategies to choose from for entering the trade. But, once you're in the trade, there are also several ways you can play the exit. In this paper, I approach this topic from several angles. Along the way, I hope you'll find some ideas that will help you develop better exits.

But first, an apology of sorts. When I decided to tackle this subject, I envisioned an easy two-page guide for exiting the trade. But, as I began writing, I realized an over-simplified approach to this topic would not do anyone any favors. A guide to exiting the trade cannot be too simple because the market does not give us simple trades. Each trade is unique, following its own path. And we will trade best when we consider all of our options.

As a result, some of this material may be too complicated to you at first. If you are looking for a quick and easy solution that requires no thinking on your part, then you won't find it here. Instead, you will be shown various exit strategies and then we'll place those strategies within the context of different types of trades. You may need to take the parts of the article that make sense to you now and come back to the other parts later. But, hopefully, you will think through your own exit strategies and develop ones that make you a more successful trader.

The Purpose of Trading

What is your major objective in trading stocks? Your answer may be the obvious one, "to make money". But it might be better to refine the answer a bit and say "the objective of trading stocks is to preserve equity and earn the maximum profit". If we place "preserve equity" first in this definition, then it clarifies the inherent risk of trading stocks. It is risky because we cannot guarantee the future movement of price. If we knew for certain that every time we purchased a stock the price would go up, then there would be little risk involved and any other occupation would make little sense. And if we place "preserve equity" first in our definition, then it provides a more sober assessment of our endeavors. We cannot control the price of the stock. We may think it will go up, based on our best analysis of news and technical ananlysis. But we have no guarantee. Nor do we have any guarantee that the price will reach our targets. The market does not care about our targets. It is not concerned with our 1% profit target on a stock. Nor does it care if we set a $1200 profit goal for this trade. It is not the market's responsibility to help us reach our goals. So, don't blame the market. Rather, it is our responsibility to manage the trade to the best of our ability in order to achieve our twin objectives of preserving equity and maximizing profit.

As I am fond of saying, "control what you can control". You cannot control price, its direction, or its speed. But you can control your actions as a trader. You decide what to do in each moment - weighing the options and deciding whether to stay in the trade or exit it. Although it is not easy, we each have the oppportunity to create a personal discipline of trading. This discipline requires that we act in accordance with a certain body of rules that we have found to accomplish our definition, "preserve equity and earn the maximum profit".

It is impossible to develop a set of rules that fits each trader's personality and risk tolerance. Nor is it possible to be 100% disciplined. Even with the best statistical rules for trading stocks, we will not always trade in accordance with those rules. Sometimes, breaking those rules will work in our favor, and cause us doubt the correctness of the rule. Sometimes, breaking those rules will have near disatrous consequences.

So, if the purpose of trading is to preserve equity and earn the maximum profit, then what is the purpose of money mangement within that larger goal? The purpose of money management is to maximize gain while minimizing loss. While most traders would agree with this in theory, their actions tell a different story. Most traders do not know how to manage the trade for maximum gain and minimum loss. And that is why they underperform. Most traders tend to stay in losing trades too long and exit winning trades too quickly, which is the exact opposite of our stated definition for money mangement.

If we tackle the subject from this perspective, then we can break money management into two questions. (1) How do we exit the losing trade to minimize our loss? (2) How do we exit the winning trade to maximize our gain? So, let's take each one in turn.

(1) How do we exit the losing trade to minimize our loss? Let me state this differently. When should you exit the losing trade? Answer: as soon as you know it is a losing trade. This immediate action stops the bleeding. The follow up question to this is: how do you know it is a losing trade? Answer: as soon as it fails to qualify according to your trading strategy. You can think of it this way. You enter a long trade according to a well defined strategy. This strategy tells you that you have a statistical edge of earning a profit if you trade it correctly. But no strategy, no matter how good, can control the future price of a stock. As the trade develops, the stock either remains qualified for this strategy or it does not. As soon as it fails to qualify, then the trade should be exited, because it immediately becomes a losing trade, even if you have not lost any money yet. This last point is significant and that is why I have set in off in bold type.

It is not the loss of equity that tells you when to exit the trade. Rather it is the disqualification of the stock that tells you when to exit the trade. As long as the stock is qualified, then you remain in the trade. Once it becomes disqualified, you exit the trade. Strategy, therefore, is paramount over profit and loss. If the strategy is sound and the trader stays on course, then the profits will take care of themselves. So, the upshot of all of this is that the trader exits the trade when the stock no longer meets the criteria for a successful trade. That may be with a three cent loss. That may be with a five percent gain. The key thing is not the amount of money at stake, but simply whether or not the trade still qualifies to be held according to our strategy.

Another way of looking at trading is to say that trading exists on a risk:reward line. The best trading strategies are those with minimal risk yet high reward. As soon as the trade commences, that ratio changes. The balance tilts either one way or the other, either toward higher risk or lesser risk - toward equity loss or equity gain. One way to manage that risk:reward line is by using stops that are manually changed based on the where the trade exits on that line. If the trade suddenly moves toward risk, then the containment of loss would mean creating a tighter stop loss in order to minimize the loss of equity. But this is exactly the oppposite of what most traders do. Most traders give the stock more room to play, thus incuring more risk and losing more money. In the same way, when the trade goes their way, most traders tighten the stop too much and thus minimize their gain.

The problem is more psychological than anything else. We hate to lose money. Some of us are so averse to losing money that we will do any number of things to avoid it. We will average down, hold trades for long periods of time, etc. in the effort to make the trade profitable again. We also hate to give up on something and we hate to be wrong. So, when we exit a losing trade, we have plenty of psychological garbage being dumped in our paths: we lost money, we gave up on something and we were wrong. That's a lot of negative stuff. By refusing to sell a stock at a loss, we don't have to face up to this negative stuff. So, a lot of our tricks are nothing more than avoidance tactics creatively designed to keep us from facing up to the terrible fact that the trade went against us.

But, if we reframe our relationship with stock trading, and treat it more as a game, then it frees us up tremendously. When we are playing a game of basketball, we don't expect to make a basket every time we aim for the basket. When we swing a bat at a ball, we know that we will not always hit it. That is part of the game. We accept our imperfections because it is part of a game. We study how to improve. We try to get better. But we know that we will never be perfect and that's okay.

So, when we reframe stock trading as more of a game, we can focus on executing a winning strategy. As the trade develops, we evaluate the play based on whether or not the stock still qualifies to be held according to this strategy. We don't focus on the money, saying "I will exit at a 3% loss". Let me ask you this. Did the stock go down 3% before you realized it was moving against you? No. When did you first realize the stock was no longer qualified? Probably back at half a percent. You don't have to wait for some magical number to be hit before you exit the trade. Instead, you exit the trade when it no longer qualifies for your strategy, or when the indicators tell you the trade is moving against you.

So, we ask the simple question: "When is the best time to exit a losing trade?" Answer: as soon as you realize it is a losing trade. For most traders, that is long before you take a 3% loss.

(2) How do we exit the winning trade to maximize our gain? If we are using charts and technical analysis to determine when to exit a losing trade, then we do the same for determining when to exit the winning trade. By using the simple cheat sheet action guide provided in this paper, you should be able to stay in winning trades longer. A first step, however, might be to sell half your shares at a predetermined profit percentage and play the remaining shares based on your analysis of the trade. This is a sort of half way step between playing the whole trade based strictly on the technical indicators. Over time, you will be able to execute the entire trade based on whether the stock still qualifies. But, a good first step is to start doing this with half your shares, after some profit has already been secured and you've moved your remaining shares to a break even stop order.

The tendency of most day traders is to exit the trade too soon. While we have reason to be happy with any profit at all, there is nothing wrong with learning how to maximize our gains either. Most traders exit at set percentages and they exit too soon. Some of this has to do with a lack of confidence. For some, a profitable trade makes them nervous. They have had the experience too many times where they failed to exit and ended up not capturing the money that was already sitting there. We've all had that experiece and it is not fun. But, a premature exit from the trade fails to maximize your profits.

Here are two things you can do to maximize your gains.

(a) You can use moveable stops. Some traders use stops to minimize their losses. Few traders use them to maximize their gains. Let me define the moveable stop. As a stock's price continues to move in your favor, creating ever expanding profits for you, then you can gradually move your stop. You can think of price as going up a series of steps. You can move your stop each time price takes another step up. You can do this on half your shares. You can create multiple exits. But the idea is to let your stop be reflective of the stock's movement. If price starts to stabalize and flatten, then you may want to move the stop tighter to catch as much profit as possible. If the stock is moving quickly, then you may want to play it a bit more loosely, to prevent a premature stop due to price volatility. But think of using stops as moveable sell orders. You don't really know how high price will go. But, by setting a stop on a profitable trade, you are guaranteed a certain amount of profit.

Some traders prefer to use trailing stops. These are stop orders that trail behind the last highest price reached by the stock, and activate an automatic sell order when the price falls below a set percentage or amount from the last highest price. The advantage of trailing stops is that it allows you to look at other stocks while locking in guaratneed profits.

(b) You can use different time frames. Most day traders use a one or five minute time frame. The problem with such a narrow time frame is that it will make you exit a winning trade too soon. So, if you have a trade that keeps moving higher, take a look at the next time frame, such as the ten-minute chart. The indicators there might show you that the stock has more room to run, whereas the tighter five-minute chart shows the indicators already maxed out.

To read Part II of this series on Exiting the Trade, then click this link.