Anyone who has been trading or investing for a little while quickly comes to this realization: knowing when to exit the trade is just as important as knowing when to get in to a trade. In truth the trade’s exit decision is MUCH more important in determining your investment performance than the trade’s entry decision.
Over the years I have coached many students who have a similar problem: they take profits too early. In hindsight they are quick to point out their error and express their disappointment. However, they often misunderstand the real problem. Their problem was NOT that they made an error of judgment at the time they closed the trade. Their problem began before they even started the trade. They did not define their exit strategy.
It is important that a trader realize what an exit strategy can and cannot do. An exit strategy cannot help you perfectly capture the most efficient profits. Let me restate that in more familiar terms: you can’t expect to buy the bottom and sell the top. Because you can’t expect to predict the perfect bottom and top price of any given timeframe, you then have to set a different kind of goal for your exit strategy.
This leads us to what your exit strategy CAN do. It can help you respond to the market in a way that satisfies you—thus improving your chances at keeping your performance more consistent. The best profits are made when you can ride a trade through a very long trend. Obviously that is hard to do on a consistent basis, even more so in volatile markets. But if you plan for it ahead of time, you might find it easier to accomplish.
As an example, imagine implementing the following strategic exit approach. If you determine that you will buy a given number of stock shares, plan ahead of time that half that number will be used for taking quick profits, and that the other half will be a longer term trade. Your strategy will be to allow the first half of your shares to ride the trend as long as you can, say a period of several weeks or months, and the second half of the shares to be used for optimizing short-term swings in durations of one week or less.
Consider how such a strategy might have worked on a stock like Royal Gold (RGLD).
Imagine that you carried out this strategy by using 500 shares for one position and 500 shares for the other. In the figure above the green line designates how you would have bought and held the first 500 shares. Using a 20% trailing stop loss, you would still be holding on to them as of the last day of this chart. The blue and red arrows represent trades that you would make with the second 500 shares (blues are winners; the one red arrow is a loser). The trades represented by the shorter arrows would have been entered based on the breakout of a previous day’s high price and sold using a stop loss of the lowest price in the previous three days.
I am of aware that this strategy underperforms buying at 105 and merely holding on for the ride. It is important to reflect that the buy and hold strategy only seems valid because we have the benefit of hindsight. As the trade is developing, you don’t know how it will go. Students I coach might often capture any one of the green arrow trades, but will rarely have the patience to take the blue arrow trade. Implementing this kind of strategy helps them to achieve gains they might otherwise not make at all.
The flaw behind a buy-and-hold strategy is that you can’t hold on to what you don’t buy, and you can’t realize a profit if you won’t sell. This two-part approach allows for a kind of compromise between the part of you that wants to make a huge winner and the part of you that can’t bear to watch temporary profits evaporate as the price fluctuates along its trend. You will buy a stock knowing that even if there is only one good swing in the trade, you will at least capture some profits from the move. With that in mind you are less likely to be over-cautious about taking the trade. At the same time your focus on maximizing short term profits will allow you ignore the progress of the first trade long enough to let its gains grow substantially.
There are many variations of such a strategy but the main component is that you will attempt to find a method that placates your own psychology while profiting from what the market gives you. In the long run your performance is more profoundly influenced by your own decisions and not so much dependent on what the market does. That is why researching and practicing an exit strategy that suits your own personality may be more worthwhile that scanning for the next hot stock to buy.
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