Going on dates with people you don’t know is so intimidating and could end in disaster as I’m sure many of you already know. Often times, the person you go on a date with has nothing in common with you or is a complete psychopath. Maybe I’ve just been watching too much Netflix lately but in my mind, I feel as if the person sitting across from me has two hobbies: burning insects with a magnifying glass and keeping dead bodies in their basement. I once went on three dates with a girl and the next time I went over to her house, she had three framed pictures of us on those dates sitting on her desk. In that moment, I wish a had an ejection button on my chest just to get me the hell out of there!
The pointing I’m trying to make of all this is that when things go bad you need to have an exit strategy. Before you go on that date, you want to know how you could end this quickly and make sure this person never contacts you again. The same can be said of your trading. In today’s article, I’m going to be explaining the importance of an exit strategy and some tools you can use to know when it’s time to dump a trade.
In the article, The Holy Grail of Trading, I talked about how 70% of my trades can be losers and only 30% are winners but I will still be turning a profit. I am able to do this because I manage risk by letting winners ride and cutting losers short. Before you ever enter a trade, you want to already know at what price you want to exit. A key question you should be asking yourself is, “what is the maximum loss I am willing to take on this trade?” It is so critical that you answer this question before you blindly buy a stock and hope that it goes up. Now let’s talk about the two kinds of exit’s you will want to make which is a stop loss (things didn’t go your way) and a profit exit (things went your way and you want to capture your gains!)
Not all trades will be winners so we need to know what price we want to get out if things don’t go our way. I have three main methods I use as a stop loss strategy:
- % Move or Price Move
o A great technique for getting out of a trade is by setting a stop loss at a percentage move down or price move down. For instance, I may enter a trade and say that I will exit the trade if the stock goes down by 3%. I do not want to absorb any more losses than that.
o Another example would be that I want to exit a trade if the stock falls $5 dollars a share. At that price, I do not want to absorb any more losses and think that it is a weak price compared to what it has been doing all year
- As a Dollar Figure
o Another method is calculating the stop loss based off of a maximum dollar amount that you are willing to lose. For example, I will enter a trade and say the maximum amount I want to risk is $300 dollars. I will calculate what price I need to put my stop loss based off of how much I invest and how much the stock is trading for.
- Technical Indicators
o The last technique is by far my favorite and the one I use the most to enter and exit a trade.
o Breaking Support– Stocks will form support lines in which many buyers step back in to drive the stock back up. If a support line is broken it is a very bearish indicator and I would exit the position based off of that.
o Volume- Volume(Amt of shares traded) drives share price. If you start to notice more volume on down (red) days and less volume on up (green days) then this is an indication that the stock is trending down.
o Breaking Moving Averages- in previous articles, I’ve talked about SMA and EMA as being good indicators of what direction a stock is heading. Often times, a stock will find support or resistance at this moving averages. If a stock breaches a moving average in a negative direction, I is a bearish indicator and might be a good time to exit the position.
You can think of the profit exit as a good problem to have. Your stock pick was fabulous and you are up in the position by a good amount. But what now? Is the stock going to continue to go up? Should I sell out now and take my profits? It is a very tricky situation to be in because we want to let our winners ride as long as possible. Here are the 3 methods I use to exit a trade when I have made a profit:
- Target Profit
o In previous articles on the charting patterns of the Wedge and Head and Shoulders pattern, I have showed you how to calculate expected target profit based on the charting pattern itself. I rely on these calculations to know when it could be time to exit a trade.
- Trade on House Money
o In some cases, it is best to book some profits and let the rest of your position ride. Let’s say you bought 100 shares of Disney and it goes up by $10 dollars a share. You could sell half of your shares (50), taking those profits, and letting your remaining shares ride out to see if Disney will keep going. The ultimate sweet spot would be to sell enough to get your principal back plus profits and then let the rest ride to see how much more you can make. That money that’s still invested is the houses money because you have all of your principal back!
- Technical Indicators
o Just Like a stop loss, we want to use the same technical indicators to know if it is time to exit a trade
o Bouncing off Resistance– Stocks will form resistance lines just like support lines. If a stock reaches a resistance line and does not break it, then it may be time to book some profits. If the stock breaks resistance, then keep letting that winner ride!
o Volume– Same as Stop Loss. If you start to see more volume on red days than on green, then the stock may be reversing its course. Take some profits!
o Bouncing off Moving Averages– Just like a resistance line, if a stock bounces off EMA or SMA and starts to head back down, then it may be time to book some profits.
Having an exit strategy is just letting making a budget. You set it and DON’T BUDGE. An exit strategy takes emotion out of investing, helps you stick to a plan, and makes it so that you are not gambling on trades. Always make a plan to get out BEFORE you enter a trade.
Homework: Think of a stock you were planning on investing in. Use one of the strategies I have provided to calculate a stop loss or potential profit exit based on what you think the stock will do.