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Trade Exits and Opportunity Costs
Consider Alternatives to Each Decision
There are many approaches to initiating trades and selecting stocks for investment purposes, but many of
the "experts" who provide advice on getting into a day trading or investment position fall short when it comes
to insights into when and at what price to get out. Let's assume for purposes of this discussion that you
have a rational basis for making the investment, or initiating the trade, in the first place, and that you
have a reasonably well-disciplined approach to cutting your losses if the price of the stock does the
opposite of what you expect or hope. Often the situation that experienced traders, and especially
long-term investors, have the most difficulty dealing with is the happy period when the price of the
stock has risen well into the profit range. How do you know when and where to get out?
A brief description of the economic concept of "opportunity cost" can help us bring some logic and good
judgement to the challenge of deciding when to exit trades. Opportunity cost is the value of the next
best thing you can do with your
resources. Your resources clearly include your money, but they can also include your time and your
comfort. For example, let�s say you bought a ticket to a show or game that you really look forward to
seeing, and when you arrive for the big event you discover that fans are offering to buy tickets from
scalpers for ten times
the price you paid.
Now, you might think that your cost of attending the event is simply the price you
originally paid for the ticket. But, in economic terms, your cost is equal to the value of your second
highest priority choice about what to do with both the time you have allocated to the event for which
you hold a ticket, and the amount of money you could get by selling your ticket at the new, higher
free-market price. Your �opportunity cost� for using your ticket to see the event rather than converting
your ticket to cash is equal to the price you could get for your ticket rather than the price you paid
for your ticket.
How does this apply to exiting a trade or an investment? It is actually quite simple.
As your profit in a given stock or investment increases, at regular points in time based on the time
horizon of your trade or investment, you should ask yourself if you would buy the asset you currently
own at the current price as a new investment or trade. If the answer is �yes� then keep holding, but
if the answer is �no� then it is time to convert to cash and take advantage of that second highest
priority trade or investment that is waiting for your time, attention and capital. Whether you are day trading
or investing for longer periods, it is often best to take the easy, early profit from a trade and then convert
to cash so you can objectively evaluate the other opportunities available to you.
Of course, you should never
let the temptation to take profits early interfere with your ability to maintain disciplined management of
your trading system or investment plan. Read Patience is the Key to Profitable Trading Systems for more thoughts on this subject.
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