Exiting the Trade

Part II - Types of Exit Strategies

In this section, I'll expand on the above ideas and review five possible exit strategies. You might look upon these strategies as available options. You might find that certain strategies work better for you than others. You might find that certain strategies work better in certain situations.

1. Percentage based stops and targets. You can use strict rules for entering and exiting the trade at specific percentages. For example, you might always exit the trade if it goes against you by 1.5% and you might take all of your profit at 1%. If you have more winning trades than losing trades, then this formula might work for you. If you use a strict trading format, then make sure it is based on your study of your personal trades. Don't follow someone else's rules. They may have a higher aversion to risk than you.

2. Average down. When a trade goes against you by 3%, you might buy more shares and average down to a new price. If this strategy consistently works for you, then great. But here are some questions you might want to honestly answer. Do you do this because it works, because you hate being wrong, or you hate losing money? Do you average down more than once on the same trade? Do you average down only if you are wrong by a certain percentage? Do you average down only when the stock meets certain technical trading criteria? Is averaging down the best use of your equity, or are you throwing good money after bad?

For those who like to average down, I will make three suggestions. (a) You might consider selling half your shares at <1% loss automatically, in order to limit your exposure to a losing trade. (b) If you decide to use that equity to rebuy the same stock at a lower price, then you will not have to use more equity to do so - you will simply be using the same equity you released at the <1% loss. (c) If you decide to average down, I suggest using a larger time frame for your next entry, to make sure you're buying the new shares at a confirmed, bottoming price. So, let me describe how these three suggestions would work together.

The problem, of course, is that averaging down doesn't always work. You can end up chasing a bad trade right down the rabbit hole, instead of taking a quick smaller loss earlier on in the trade.

3. Never exit a losing trade. Here's a nifty way to be right all the time. Never exit a trade unless you're making money on it. While this might be less damaging psychologically, there are some questions for this strategy also. Is this the best use of your equity, since you are unable to use that equity to make a gain while your profits continue to plummet? Are you using small amounts of equity so that you can hold multiple trades for days, weeks, or months if necessary? Are you willing to turn your day trades into swing trades in order to accomplish this? What does this strategy do to your average gain per day per trade (a statistic you should know, kind of like your batting average)? Without an exit strategy in place, you are essentially saying you'll never exit a losing trade. Unfortunately, this strategy fails to follow the first rule of trading, to preserve your equity.

4. Time stops. The time stop is a simple mechanisim. Basically, if a stock fails to perform up to your expectations within a certain period of time (i.e. ten minutes), then you exit the trade at the best posible price. There are several ideas behind this strategy. One, time equals risk. The longer a trade fails to perform in the manner you expected, the more risky it becomes. Second, time is money. If your equity is tied up in a non-performing asset, then your equity is not performing up to its full potential. Why waste time with a stock that is just treading water when another stock choice might be earning you a profit?

5. Trade the charts. Win, lose, or draw, you can learn to play each trade based on what the technical indicators are telling you. You can quickly interpret data and make judgements based on that data. But this sort of trading does not come quickly to the new trader. It only comes with time and lots of trading experinece. And even then, a good trader can use a good strategy and still lose money. This is possible because sometimes a stock can change directions quickly. A stock can qualify and then become unqualified in a matter of minutes. Price can start to run up and then face an avalanche of panic selling that drives the price down quickly. This will show up in the price and the indicators. But still, you can learn to trade the charts, without using any stop loss orders. Here are some questions for those who like this strategy. Do you tend to interpret the charts based on what you want them to say to you, or are you fairly objective in the interpretation? Do you add certain trading rules to your chart interpretations, just in case you're occassionally wrong? Are you disciplined enough to trade this strategy on a consistent basis? When using this strategy, do your net earnings per day exceed those days when you use other strategies?

It is possible that your best strategy is some sort of detailed combination of all of these strategies. It is possible that you might use different strategies in different situations. It is also possible that your choice of strategies may develop over time, as you become a more experienced trader. So, for example, a trader in his first year of trading may need to use strategy #1, while a person who has been day trading profitably for five years may comfortably use strategy # 4. What works well for one person may not work well for someone else. Part of this is experience and part of this is personality. Some traders need strict guidelines that state with great certainty "do ___ whenever ___ occurs". Other traders find that strict, rule-based trading doesn't work to maximize their profits.

But here is the ultimate question for whichever strategy you employ: does it help you protect your equity and maximize your profits at this point in your experiential time line? So, the first thing is to develop an exit strategy of your own that works for you right now. The only way you can figure this out is by spending time with your trades and asking yourself the tough questions related to "likes" and "wishes". "This is what I liked about how I played this trade. This is what I wish I had done better. Would a different exit have made more sense on this trade? How could I identify that exit on future trades?" Ask these tough questions on every single trade until you're comfortable with your own exit strategy. Don't consider your trading day complete until you've answered those questions. As you gain experience, you may find that some exit srategies work better in certain situations. And you will become a better, more profitable trader.

To read Part III of this series on Exiting the Trade, click this link