Exiting the Trade - Part III
In Learn Stocks, I cover the last aricle in this series discussing various exit strategies.
5. 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. For the new trader who is just starting to learn stocks and trading, this can be very frustrating. Heck, it’s frustrating to anyone. 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 as you continue to learn stocks and how to trade them. Before we get into strategy, 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 as you learn stocks and how to trade them 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 buy the stock again and average down at a lower price. But, as you learn stocks and trading exits, you’ll find that this is a risky strategy.
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 purchase the stock again at a lower price if (and only if) the stock qualifies 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%. The key thing is to take some action rather than just staring at the bad trade like a deer caught it the headlights.
My suggestion for those who are trying to learn stocks 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 of price movement. 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 enter the trade a few minutes later if it qualifies.
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".
You may want to go back to the beginning of this three-part series. You can click on Learn Stocks to go back to that first article.
Here's a YouTube video that shows some stock chart examples of these five exit strategies.