Simple and Logical Trade Exits
Know When to Go to Cash
Most traders and investors have no trouble deciding when to get into a position,
but a majority of novices, and even those with far more experience, falter when asked
to describe how they decide when to convert back to cash. There are few aspects
of trading or investing more important than a clear method for determining when
to end a trade or cash out of an investment, either with a trading profit or a trading loss.
First, let's define a couple of terms: For purposes of this discussion, a trade
is any position, long or short, intended to be held for anywhere from minutes to
weeks. An investment is a position, either long or short, that is expected to
be held for months to years.
Most investors and traders use either fundamental factors or technical
indicators to determine when and where to enter a position. Anyone who doesn't
use one or both of these general approaches is probably neither a trader nor an
investor, but just simply a gambler. The entry criteria of most high-quality
fundamental and technical approaches and stock trading systems are derived from significant research into
what works and what doesn't. Unfortunately, the research is usually much more
thorough on how to buy stock than on when to sell stock or close the position.
It is unlikely that you would undertake a home remodeling job without a clear
idea of what you wanted to have when you were finished. You are also unlikely
to begin a trip without some idea of where you want to end up. Why is it then
that it is so easy to enter a new position with only a vague idea of what
criteria, if met, clearly say it is time to go to cash?
Many "gurus" of trading and investing have said to "Cut your
losses and let your profits ride," but that is almost as obvious and inane
as saying "Buy low and sell high." So, how do you decide when and
where to get out? A good stock trading system will address this issue
in just as much detail as the entry techniques. Here are some rules to follow. They work.
When you enter a positon, immediately write down your expectation of events (in
the case of a fundamental approach) or patterns (in the case of a technical
approach) that will represent a change in the circumstances that led you to take
the position. Also note down the total time you are willing to allow for things
to happen. If the events or patterns have not ocurred within the time you
determine in advance to be reasonable at the entry point, then go to cash. If
the events/patterns occur go to cash no matter where the price has gone. Do not
worry about what happens to the price afterward. Good stock trading systems (or systems for commodities or forex
) will be profitable if you follow the rules.
Your timeframe will determine
the magnitude of profit that is reasonable to expect. A long timeframe
logically can yield a greater profit than a short timeframe. However, a trader
with a short timeframe can be just as successful in relation to his initial
objectives as an investor with a long timeframe.
Let's look at a real example for illustration. A trader who bought Microsoft
(MSFT) the week of October 27, 1997 would have paid about $130 per share. That
trader could have sold his position the week of December 1 for at least $143 per
share for a nonleveraged profit of 10% in only five weeks - an annualized profit
of approximately 100% not counting the very important negative impact of
commissions and slippage. An investor who bought at $143 per share that same
week would have endured a drop to $122 over the next three weeks, but if the
investment were held for at least a year, he could have sold at a split-adjusted
price of $268 per share, or 87% profit in one year, slightly less on an
annualized basis than the trader, but better after adjustment for lower
commissions (fewer trades) and long-term capital gains tax treatment.
NEVER, EVER allow yourself to change your planned timeframe or event/pattern exit criteria
after you initiate a position.
Doing so in the hope of capturing an early profit or in the hope that a losing trade will redeem itself
by holding out a little longer may improve your single-trade profit from time to time, but will
inevitably lead to chronic violation of your own trading rules and will prove to be a short-cut to
failure. Make a plan and stick with it. Good stock trading systems will have rules for entries as well as exits.
If your research is good and you trade with discipline, you will
succeed.
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