Exiting the Trade

Part III - Five Types of Trades

Now that we have five possible exit strategies, we can apply these to different sorts of trading situations. In this section, I will descibe five different types of trades. As you have probably discovered, you can use the same entry strategy on different stocks and get very different results. The reasons are simple: each stock is different and we cannot control the future movement of these stocks. So, once we have entered the trade, we have to play each trade in the appropriate way. One of the great things about day trading is that we have extreme freedom and flexibility when it comes to exiting the trade. As qualifed day traders, we can enter and exit a trade as often as we wish.

So let's look at five possible types of trades. How we exit each pattern will make a difference in our success as traders.

1. The perfect pattern. This is the stock that forms a perfect pattern within a single time frame. If we're playing it long, then it makes a perfect arch with the candles forming higher highs and higher lows. The price action gives us little reason to exit the trade until it makes a nice leveling off period in which we calmly exit the trade with a sweet profit. Exiting a trade like this is easy. You watch for price to slowly level off, moving your stops up as price goes higher. Then, once you think the top price has been reached, you calmly exit your entire position at the highest possible price. Oh that more trades were like this one.

2. The ping. This is the stock that shows all signs of going higher, but then it stops and bounces back and forth within a narrow channel. As it does so, price enters a tight Bollinger Band squeeze and it becomes anyone's guess as to which way price will go next. My belief is that time equals risk. The longer you are in a trade that fails to move in your direction, then the riskier that trade becomes over time. So, with a pinging stock, in the interest of preserving equity and reducing risk, your best exit is often at the top of the ping line, rather than nervously exiting at the bottom of that channel. Unfortunately, most traders set a stop loss order below the bottom channel and do not exit the trade until it becomes a losing trade. The lesson here: it's okay to exit a trade at break even if the stock no longer qualifies as a winner. You do not have to wait for it to become a loser.

3. The rocket. This is the stock that takes off suddenly, as soon as you enter the trade. Price might zoom up 3% within five minutes, quickly going past your target. But, as you've seen, sometimes these rockets fall as quickly as they rise, with volality taking away your profit almost as soon as it gives it to you. Having seen that potential profit (and yet failing to exit the trade at that point) you can get slightly distraught and decide to wait until you get that profit back, as if the stock owes you something. Just remember, the market owes you nothing. It doesn't care about your situation. You may never see that top price again.

There are two ways to play the rocket. One is to exit as quickly as possible and accept the gift as just that, a gift. If it ends up going higher, then you may end up missing some profit. But, often, an exit at the tip of the five-minute rocket candle is an excellent exit. The other way of playing the rocket is to quickly move your stop to a profitable position. In this way, you secure some profit while you wait to see if the rocket goes higher. A third possibility is the combination of these two strategies, taking half of your exit at the tip of the rocket while moving the other half of your shares to a guaranteed profit. Whichever strategy you choose, speed is often critical.

4. The sudden reversal. This is the stock that looks like it is forming a strategy set-up and then, almost as soon as you enter the trade, it goes against you. We might sometimes call this a pre-mature entry, because it often happens when we buy a stock before it's complete set-up has been established. But it can also happen due to extreme market volatility or a simple head fake, in which the set-up for your strategy is established and suddenly evaporates after you've entered the trade. This move against you can happen before you have time to set a stop in place. In this case, your position is negative almost immediately, and you have suddenly violated the first principle of preserving equity - you have lost money. Now what?

There are several possible exit strategies for this sort of trade. You'll have to see which one suits you best. Before we get into strategy, however, I'll ask you a simple question. When is the best time to exit a losing trade? The answer: as soon as you realize it's a losing trade. So, if your stock suddenly becomes disqualified, then you exit the trade immediately. If this happens to you too often then you may need to re-visit the rules for your set-up. Another option is to exit half of your trade immediately. A third option is to hope for the stock's recovery as you wait to exit at break even. Whatever path you choose, a lowering of expectations for this trade is suggested. Whereas your former goal might have been a 2% profit, you might now be very happy just to break even. Another option is to sell half of your position immediately and use this equity to rebuy the stock and average down at a lower price, using a larger time frame (as has already been discussed) if the stock requalifies.

I do not suggest an arbitrary "averaging down" in which you always throw more money at a bad trade while you think to yourself "it must come back up". A stock doesn't have to bounce back. It can continue to go down further. So, if you cannot stomach taking the loss on the whole trade, then one option is to exit half the trade at some predetermined level (hopefully, less than 1% from your entry price), and then use that exit equity to repurchase the stock at a lower price if (and only if) the stock requalifies according to a more conservative time frame. Otherwise, you can simply exit the remaining half shares at another lower stop loss (hopefully, less than 3%), so that your total average loss on the trade is always less than 2%.

But, my suggestion is that you not follow the knee-jerk reaction of averaging down and adding more equity to a losing trade just because the trade is moving against you. In fact, my experience has been that a stock that goes against me will usually continue to go against me. So, a "Stop & Reverse" is often the best course of action. With a Stop & Reverse", you exit the trade as soon as you've recognized your error, and you trade in the correct direction. Instead of following it down the rabbit hole, you can get out completely and short the stock. If and when the stock makes a new bottom, then you can cover the short and then go long at the new lower price. This sort of quick action will give you the best results. But it demands a rapid response on the part of the trader and a clear sense that the first trade was an error.

The bottom line for exiting a losing trade is this: you can always get back in. If you are not convinced that the trade is going in the right direction, then you can exit the trade. You can always reenter the trade a few minutes later if it requalifies.

5. The steady climber. This is the stock that goes up after you purchase it, goes past your target, and you wonder when you should exit the trade. Do you exit once it hits your target, even though all indicators show that price can still move higher? Do you have a limit on how much you're willing to make on one trade? The best exit strategy for this stock is to use moveable stops, gradually moving your stop order up, to match the slowly moving price. As the minutes go by, you successfully lock in higher and higher profit, while having less and less stress regarding the exit. You might also look at the larger time frame to see how price and indicators look there. Sometimes, these larger time frames (i.e. 10 or 15 minute charts) can help you stay in a trade longer, so you can "maximize profit". When your analysis tells you that price has probably peaked, then you can take away the stop and simply exit the trade at that peak price. Another option is to take some profit off the table as the stock continously steps up. There is no rule that says you have to exit all of your shares at the same price.

So, there are five types of stocks with possible exit strategies for each one. Perhaps you can think of other patterns. And perhaps you will think of personalized exit strategies for each pattern that suit your trading style better. But hopefully this discussion will get your started in developing a plan of action where you can "preserve equity and earn the maximum profit".

To read Part IV in this series on Exiting the Trade, click here.