Exit Strategies: A Key Look

Money management is one of the most important and least understood aspects of trading. Many traders enter a trade without any kind of exit strategy and are often more likely to take premature profits or run losses. Traders should understand what exits are available to them and attempt to create an exit strategy that will help minimize losses and lock in profits.

Key Takeaways

• The decision of when to buy a stock can sometimes be easier than identifying the appropriate time to sell.
• Identifying exit points is key to limiting downside losses and taking profits before those opportunities disappear.
• Stop orders are a useful tool for acting on your exit strategy.
• Stop orders can be updated as your view on the market changes.

How to Exit a Trade

You can only get out of a trade in two ways: by taking a loss or by making a gain. We use the terms take-profit and stop-loss orders when talking about exit strategies to refer to the kind of exit being made. These terms are sometimes abbreviated as “T/P” and “S/L” by traders.

Stop-loss (S/L) orders

Stop-losses or stops are orders you can place with your broker to close a position automatically at a certain point or price. The stop-loss will immediately be converted into a market order when this point is reached. These can help minimize losses if the market moves quickly against you.

Stop-losses are always set above the current asking price on a buy or below the current bid price on a sell. Nasdaq stop-losses become market orders when the stock is quoted at the stop-loss price.

There are three types of stop-loss orders:

1. Good ’til canceled (GTC): This type of order stands until an execution occurs or you manually cancel the order.
2. Day order: The stop-loss expires after one trading day.
3. Trailing stop: This stop-loss follows at a set distance from the market price.

Take-profit (T/P) orders

Take-profit or limit orders are the same as stop-losses in that they’re converted into market orders to close a position when a point is reached. Take-profit points adhere to the same rules as stop-loss points in terms of execution on the exchanges. There are two differences, however.

1. There’s no “trailing” point. You would never be able to realize a profit otherwise.
2. The exit point must be for a profit, below market price for a short trade and above price for a long trade.

Developing an Exit Strategy

Consider three things when you’re developing an exit strategy. 

1. How long am I planning to be in this trade?

The answer depends on what type of trader you are. Focus on these factors if you’re in it for more than one month.

• Set profit targets to be hit in several years. This will restrict your amount of trades.
• Develop trailing stop-loss points that allow for profits to be locked in every so often to limit your downside potential. The primary goal of long-term investors is often to preserve capital.
• Take your profits in increments over a period to reduce volatility while liquidating.
• Allow for volatility so you keep your trades to a minimum.
• Create exit strategies based on fundamental factors geared toward the long term.

You should concern yourself with other issues, however, if you’re in a trade for the short term.

• Set near-term profit targets that execute at opportune times to maximize profits. These execution points commonly include pivot point levels, Fibonacci and Gann levels, and trend line breaks.
• Develop solid stop-loss points that immediately get rid of holdings that don’t perform.
• Create exit strategies based on technical or fundamental factors affecting the short-term. 

2. How much risk am I willing to take?

Risk is an important factor when investing. You’re determining how much you can afford to lose when you determine your risk level. This will identify the length of your trade and the type of stop-loss you’ll use. Those who want less risk tend to set tighter stops. Those who are willing to assume more risk give more generous downward room.

Important

It’s also important to set your stop-loss points so they’re not set off by normal market volatility.

The beta indicator can give you a good idea of how volatile the stock is relative to the market in general. You’ll likely be safer with a stop-loss point that’s 10% to 20% lower than where you bought if this number is between zero and two. You might want to consider setting a lower stop-loss, however, if the stock has a beta that’s upward of three or find another important level to rely on. This might be a 52-week low or moving average.

3. Where do I want to get out?

Why would you want to set a take-profit or exit point where you sell when your stock is performing well? Many people become irrationally attached to their holdings and hold their equities when the underlying fundamentals of the trade have changed.

Traders also sometimes worry and sell their holdings even when there’s been no change in underlying fundamentals. Both these situations can lead to losses and missed profit opportunities. Setting a point at which you’ll sell takes the emotion out of trading.

The exit point itself should be set at a critical price level. This is often at a fundamental milestone such as the company’s yearly target for long-term investors. It’s often set at technical points for short-term investors such as certain Fibonacci levels or pivot points by short-term investors.

Putting It Into Action

Exit points are best entered immediately after the primary trade is placed. Traders can enter their exit points in two ways.

Most brokers’ trading platforms have the functionality to allow for entering orders and many brokers allow you to call them to place entry points. There’s one exception, however. Many brokers don’t support trailing stops. You may have to recalculate and change your stop-loss at certain time intervals as a result such as every week or month.

Those who don’t have the functionality that allows for entering orders can use a different technique. Limit orders also execute at certain price levels. You effectively place a stop-loss or take-profit point by putting in a limit order to sell the same amount of shares that you hold because the two positions will cancel each other out.

What Are the Fibonacci and Gann Levels?

Fibonacci retracement levels are prices that form a line on a chart to indicate potential areas of support and resistance. Gann indicators also predict support and resistance levels. Both are popular trading tools.

What Is a Moving Average?

A moving average is a technical indicator that’s based on a given period. It gathers data from that timeframe and uses the information to arrive at an average direction of a trend. It’s referred to as “moving” because it’s often recalculated fairly frequently to include the most recent price changes.

What Should I Consider When Determining My Risk Level?

A few factors are commonly taken into consideration when a trader is gauging their risk tolerance. How long before you’re going to need the money you’re investing? Is your horizon long-term or are you planning for retirement while you’re still in your thirties? Is your primary goal a significant gain or is it safety? It can all come down to your personality. How brave or timid are you? Consider finding a middle ground if you’re unsure.

The Bottom Line

Exit strategies and other money management techniques can greatly enhance your trading by eliminating emotion and reducing risk. Consider these questions before you enter a trade and set a point at which you’ll sell for a loss and a point at which you’ll sell for a gain.

Disclosure: This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek extensive education on the topic.