Every trader knows that even if his trade begins with an entry into a position (whether it is to buy or a sell an asset), the real payoff comes with the exit. The initial purchase (or sale) with which the trade began is important, no doubt. Getting in and taking a position at the best possible price is a good start. But it is the closing of the trade or the exit that rounds off the transaction.
It is no wonder, then, that having an exit trading strategy is vital for any trader’s game plan. There are many ways to approach the exit but often it is best to find the ones that are simple yet effective.
Understanding Exit Trading
To understand the strategies that can help you manage your exit from a position well, we should first examine some basic concepts around this.
The holding period
Between the point of entry and the point of exit lies the period of holding of the stock. This is the holding period that is crucial and plays a big role in the ability of that trade to turn a profit. It is also an integral part of the overall trading strategy for each type of trading.
For instance, for shorter duration trading such as day trading, the holding period can be as brief as a minute and extend only to hours. In swing trading, this extends from a few hours to a few days. A longer form like position trading can see the period extend from a few days to weeks on end. Finally, when it comes to investments, it runs into months and even years.
It is important to adhere to the holding period recommended for each trading type. Otherwise, there is a risk of the trading objective changing from what is intended. For example, if a swing trader decides to hold on to a stock for months because it did not appreciate as expected, this is not a good exit practice. An experienced trader would maintain discipline and stick to the norms of holding in line with a healthy exit strategy.
Timing your exit
Being cognizant of the risks and the rewards of a trade is a good first step to planning the timing of your exit from a position. Identify targets for both by referring to the technical charts that tell you both the resistance and the support levels. These should be used within the duration of the holding period suited to your trading type. Base your exit point at the ideal reward to risk ratio mark of 2:1.
There are other timing techniques too that can steer you in the right direction. Watch out for the rate of change of the price as the speed at which it advances towards the resistance or the support will be key to your timing your exit too. You can choose between a blind exit strategy upon reaching your target or opt for a protective stop for higher gains. In a slower moving market, you can also decide to go for a profit protection strategy at the two-third mark of your target. Likewise, a trailing stop can give a cover for a section of the profits earned.
A Look at Exit Trading Strategies
When devising an exit trading strategy, you need to take some factors into consideration. Let us take a look at three factors that need to be taken into account when developing an exit strategy.
This is based on the duration of the holding period. So, how long are you planning to be in the trade? Depending on whether you are a short term or a long term trader your exit strategies will change.
If you are a long-term trader then:
- Set your profit target for your long-term trade so that it does not hit during the term. However, this will limit the number of times you trade.
- Reduce risk and lock profit. Combining trailing stops with stop-loss orders will limit your downside potential.
- Take incremental profits to reduce volatility.
- Keep your trades to a minimum.
If you are a short-term trader then:
- Set short-term profit targets to maximize profits.
- Get rid of lean holdings.
- Go for exit strategies based on technical or fundamental factors.
The Risk to Reward ratio
This is based on the point at which you plan to exit. Every trade has an inherent risk and reward possibility. The Risk to Reward ratio - RRR - is an indicator as to how much capital you can risk for the reward being chased.
The idea is to set tighter stops for lesser risks and for those who want to take more risk to give an additional downward room.
The Risk Tolerance
This is the degree of risk you are prepared to take and assessing the points or stops at which you want to exit the trade.
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Where Do You Want to Get Out Of a Trade?
The exit point, for long-term investors, is mostly fixed; it could be during a yearly economic announcement or the company's yearly target. For short-term investors, this is set at execution points, such as trend line breaks, Fibonacci numbers, Gann levels, pivot points etc.
As for the exit strategy itself, a trader can choose from a range of techniques that are tried and tested for various situations. These largely depend on factors like the complexity of the trade, the market conditions, the experience levels of the trader and so on.
Here is a look at the main, commonly used strategies that vary in their approach but can be effective when used in the right situation.
A stop loss is an order you can place to exit a position in when the target price of the trade slips below the market price. This can be automated in the form of a sell order once the stock hits the set price, thereby enabling you to exit the trade.
This is a useful tool to exit a trade and helps minimise losses that can spiral out of control in the absence of a measure like this. Often, in a fast-moving market scenario when you are working on multiple trades, keeping a manual tab on the movement of all your stocks may not be practical. This is where an automated stop loss can act as a safety net when it prevents further damage in the event of a slippage.
There are variations of the stop loss that can be used depending on the situation. While a guaranteed stop, with a pre-determined price, can eliminate the risk of slippage, a trailing stop is more sophisticated in its function. Here, you get the advantage of the stop consideration trailing the market movement in an upward trend and locking in at a pre-set point when it drops.
Here the system works in the opposite direction by setting a level when the market moves up and you stand to make a profit. The take profit order is set at a price most favourable to you in terms of gains and triggers once that level is reached.
This is helpful when there is overall positivity in the market and, especially, in the stock you have taken the position in. There is a downside here, though. If the stock is likely to have a strong run and promises a strong upside, a take profit order can thwart its potential to make the high gains it can provide.
But, if there is overall volatility, markets or the stock can, theoretically, go either way. It pays to watch out for the requirement to have a stop loss too to complement the take profit order.
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Some traders might prefer to cash in on the profit as and when possible. A trailing stop is a strategy that helps you secure a gain when the market moves favourably. The trick here is to keep the stop closer to the market price such that you are in with a better chance to register a profit.
The essence of a trailing stop is to ensure that there is always a possibility to land a profit, no matter how small it is. But there is also a fine balance a trader needs to maintain between that and being cautious enough to avoid aborting a potential good run towards higher gains.
There are occasions when your trades may not go as planned. The targets you set may not get hit during the planned time frame. It is possible that the trades may not result in a profit but having your capital locked up without performing can be a bigger loss. There is the risk of missing out on other good opportunities due to the delay in the exit.
When you observe that a trade is getting stagnant and not showing promise, it is best to go with the time stop strategy and exit it to pursue other opportunities.
There can be situations where you entered a trade with a certain reason or based on a premise. These could have a basis in fundamental reasons or a market or macro trend that prompted the entry into a stock. But then you realise that the background has changed enough to not stay invested. This can call for an exit from that position.
An effective and simple exit strategy can improve your trading by reducing risk. Whatever the exit strategy you adopt, what is important is for a trader to not dwell or obsess over the outcome. Instead, learn from whatever transpired and plough it back into your trading know-how.
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