Exit Strategies

Potential comes from the purchase but profit comes from the sale. It takes both a buy AND a sell to put money in your pocket.

Exits are where money is won or lost in trading. You need to plan two exits from every position, a protective exit for when things go wrong and a profit-taking exit for when things go right. Part of your job is establishing rules that will tell you it's time to get out of a trade. The other part of your job is actually closing the trade when your rules say so.

An exit signal is like a red light at an intersection. A red light doesn't force you to stop. You could drive on through the intersection, and there is some chance you will make it through unscathed. But the red light tells you two things. First, the odds are against you. Second, if something does go wrong, the damage could be catastrophic. You can't very well call yourself a good driver if you ignore red lights, and you can't call yourself a good trader if you ignore exit signals.

Initial Protective Stop

Your protective exit is the price that represents your decision about what marks the breaking point of the trade. Face it. No one can see the future. You open a position based on whatever information is available at the time and if the trade doesn't work out, you need to get back out of the position with as much of your money as possible. Amos Hostetter referred to this stop as, "Keep the cheese. Let me out of the trap!"

Your initial protective stop must be chosen before you open the position and put into force as soon as your purchase order is filled. Your initial protective stop is the first step toward cutting your losses short and letting your profits run. Once you are in a position, your ability to be objective about what is taking place is seriously compromised, so you have to take this step before opening the position.

Once you're in a position and you have your initial protective stop in place, then you have to manage the position, which boils down to when you are going to exit. Like the initial protective stop, your exit strategy is something you must decide on before entering the position. Fortunately, there are a variety of exit strategies available.

Price Target

If you have a method of calculating a price target, then you can place a GTC (Good Till Cancelled) limit order at that price. Be sure to set both your initial protective stop and your limit order as OCO (One Cancels the Other) orders.

I have never found a satisfactory way to calculate price targets so I don't use limit orders and can't tell you much more about it. If it interests you, my advice is to find someone who manages their positions this way and get them to coach you.

Moving Average

Some people use a moving average as their exit signal. That is to say, when price crosses or closes below the moving average, they close the position. A short average will track the stock closely. It minimizes how much profit you give back when price turns down; however, it also means you can be stopped out by a relatively minor decline. A longer moving average will ride further from price action. This means you will give back more money (as a percentage) once price begins to decline, but it also means you will be less likely to get stopped out by short-term volatility.

If you use the crossing the average as your exit signal, then the value of the moving average can be used to update your protective stop each evening. The disadvantage of this approach is that a burst of volatility may cause price to swing below your sell stop and you will be closed out of the position prematurely.

If you prefer to use a daily close below the moving average as your exit signal, then a limit order will not be useful. You can check the closing price each evening and if it closes below the moving average, place an exit order to be executed when the market opens. This method requires more work, but it gets around the problem of intra-day volatility washing you out of the trade.

Trendline

The trendline itself can be used as your exit level. As with the moving averages, price crossing the trendline can be handled with a stop order, but a close below the trendline will have to be checked each evening.

Trailing Stop

There are various kinds of trailing stops that can be used as exit levels. An adaptive trailing stop that follows price at 2 or 3 times the ATR (Average True Range of price) can be good. Welles Wilder's Parabolic Stop and Reverse can also be a good choice for exit signals. (The Parabolic SAR is not good for entries because it tends to get you into trades too late, but it works well for exits.)

MACD

In the 1970s Gerald Appel created the Moving Average Convergence/Divergence indicator, the MACD. It worked very well until its popularity started to erode its usefulness. When too many people are all using the same entry and exit points, they stop working. The decline in its popularity plus the proliferation of other tools and indicators has restored much of its value.

However, the MACD is not without its drawbacks. When the trend of the market is horizontal, the phase lag of the indicator can cause you to amass a string of small losses. This problem can be vastly reduced by using the MACD in conjunction with tools that will warn you when the trend has gone flat – like trendlines, for example.

Our software uses a rise in the MACD to confirm some of the L entry signals. I personally use the MACD as an exit signal. When the MACD has been above its trailer line (also known as the signal line) and then drops below it, I close my position. This results in relatively short trades often only 5 to 10 days in length and this may be too short a holding period for you.

Alternatives

There is an alternative to closing a position when the exit signal arrives. Instead of actually closing the position, some people prefer to put a tight sell-stop order underneath price action. The sell-stop order automatically gets you out if price drops, but allows you to stay in the position if price continues to advance.

Putting a tight stop under price action is more appropriate for longer term trading strategies, and it is not without some costs. First, it generally gets you out at price that is lower than if you simply put in a sell order to close the position. Second, it almost always gets you out at a price that is lower than the stop level itself. (When a stop order is triggered, it does not sell at the stop price, it turns into a market sell order.) Third, it may not work out the way you had hoped, because a transient spike may trigger the stop order before the next upward leg in the rally (assuming there is another upward leg).

Final Thoughts on Exit Strategies

When choosing an exit strategy, part of your decision has to be based on your objectives and part on what you can live with. You can have the greatest exit strategy in the world but if you can't act on the signals it gives you, then it is no use at all. Like the rest of your trading system, your exit strategy has to fit your personality and your beliefs.

One of the hobgoblins of amateurs is the fear that a security will go higher after they exit and they will miss out on some profits. I can guarantee you that about a third of the time, price will go higher after you exit. Deal with it.

Trading is all about probabilities. You don't open a position on a sure thing (because there arent any). You open a position when there is a high probability price will move in your favor. You don't exit a position because you think the market will not move further in your favor. You exit because risk is starting to outweigh reward. If you try to capture every last cent of a move, you will end up losing more than if you had followed your signal.

When the signal comes, take your profits and be grateful.