One of the biggest challenges facing traders when trading the share market is when to sell. Usually a trader will be armed with many theories on how to pick the best trades to enter the market, but when asked where they should exit you often get a confusing array of examples that are in most cases more guess work than solid theory. And herein lays the problem of the modern trader and the subject of this article.
The fact is that if you want to be a consistently profitable trader not only do you need to know how and why you are entering a trade, but more importantly you need to know when and where you will exit. A common statement made by many traders is that they only ever achieve a good profit if they can pick their entry well. However, while this statement has some merit, it is only partly true and in my opinion not the most important element of a successful trader.
We all know we can be right in our analysis less than half the time and still be profitable, as long as the winning trades outperform the losing trades. However, what I am proposing is that trading is not just about picking winning trades, rather trading for profit is about using sound money management rules and good exit strategies.
You have probably heard the statement that ‘you can’t go broke taking a profit!’ But in my opinion, this is a myth that is not only detrimental to your trading but one that will set you on a path to financial mediocrity as it will cost you a lot of money. While we acknowledge we can be right less than half of the time and still make money, we can only do this if we allow our profits to run and cut our losses short. This is because I can be right four out of every five trades but my success and profitability will depend on how I handle each trade in regards to my money management and exit rules.
Let me explain, if I have four winning trades that make 20% each and one losing trade that loses 10%, then I am profitable. I would have made 80% profit and lost only 10%, which means I have made 70% over all. However we need to remember the fact that if you lose 10% you need to make 11% to break even again, as we have less capital to re-invest. Now let’s look at a slightly different example.
If I decide I am happy making 10% on my profitable trades and I lose 20% on a losing trade then my profitability changes dramatically. Let’s say I place $1000 in five trades, I would make $400 in total on my winning trades and my losing trade would cost me $200. As a result your $400 profit is reduced by half to only $200, and your total return for the five trades is only 4% gross before costs. Not forgetting the fact that when you lose 20% you need to make 25% to break even, so the more you lose the harder it is to get back on top again. If we allowed the losing trade to continue to fall to a 40% loss then we would be in an unprofitable position on the whole portfolio.
How many times have you decided to take profits on a trade before the stock told you that it wouldn’t rise any further, and how many times have you lost 20% to 40% in a trade? If you are not a consistently profitable trader then maybe you should look at your money management rules and your exit strategies rather than spending time trying to pick the next big winner.
So how do you know when to hold onto shares and when to sell?
The simple answer is really dependant on the length of time you want to trade and the type of market you are trading.
Of the many thousands of traders I have spoken to and assisted over the years a very consistent theme continues to shine through. That being that traders exit good trades believing they are bad or exit before the stock indicates to do so. This usually results in a trader experiencing lots of minor losses and low profitability, which in many cases means traders lose overall.
Remember that the market is not 100% black and white, therefore as traders you need to allow room for the market to move. We cannot say that a market will turn at an exact point in time or price, we can only indicate with a probability derived from our analysis that this will occur. One of the most important rules I have ever learnt is to trade on confirmation and not speculation, which means you should never make a decision until the market tells you what it will do.
It is very common upon entering a trade for the inexperienced or un-educated trader to exit after a stock has moved down for a few days or even a few weeks only to see it rise up to make a nice profit after they have exited. Others traders will buy a stock and then after a few weeks of it trending up sell if it pulls back for a few days which usually results in lots of small profits. When I explain that this is in fact detrimental to their overall profitability and that they should implement some simple rules, they are often surprised to find that by following some simple rules they are much more profitable.
Often a trader’s reaction to exiting a stock is based on their fear of losing and a lack of faith in their trading plan (if they have one), or their ability to be profitable. I guarantee you that if you have a written trading plan that you have back tested over many years on many different stocks that has proven you can be profitable, then you will have faith in your plan and your ability to enact that plan.
I personally hand charted five stocks for a whole year before I really started to trade and I back tested my trading plan to make sure I could work it and make money. Yes it was hard holding back from actually placing my money on the market because in my mind I felt like I could make money if I was trading. But the fact of the matter is that most people are so fixed on putting their money on the market as fast as they can to make money they actually end up losing because they are ill prepared.
If after you read a book on skydiving I said to you lets get into a plane and jump, you would probably think I was crazy and a risk taker. In fact, I am sure if you were standing at the door of the plane with nothing between you and the ground I am sure you would be wishing you had spent a lot of time practicing the skill to ensure your success. The best traders I know spend a great deal of time practicing and back testing their trading plans, and you can guess who are the most profitable on the market
So the question is how do we know when to exit a trade?
If your intention is to trade blue chip stocks for the medium term, then setting a price target on a profitable trade is what I call financial suicide. Your job as a trader is to take the lowest possible risk each time you trade. So why would you consider exiting a profitable trade when you know with 100% certainty that the stock is going your way. Not only will you be taking smaller profits but you will most likely enter another trade that you won’t know will be profitable. If you are using trend following indicators such as trend lines and moving averages, let them do the work for you by telling you where to exit; do not second guess them by exiting early.
Setting tight stop losses on blue chip shares is another area in which many traders fail as they exit too early. Remember you need to let a stock settle into a trend after entering, but if you set a stop loss of 5% not only is there very little room for the stock to move but you will decrease your profitability. The minimum you should set your stop loss at on these types of stocks is 10%, although depending on their volatility my preference is around 15%.
If you trade speculative stocks then you need to use analysis tools that are very sensitive to market changes, but once again you should wait for confirmation rather than speculate on a move. Tools that work effectively on speculative stocks include Dow Theory, Swing Charts, Fast Moving averages, MACD’s and Stochastic’s to name a few. Your stop loss also needs to be tighter than if you were trading big blue chip stocks, but be careful not to make it too tight as you will get stopped out more often than you would like.
If you are an options trader then things will obviously be very different because you are trading a highly leveraged and fast moving market. Therefore your exit strategies will need to reflect this because even if you wait an hour at times to exit a position you can lose a huge chunk of your money. Once you enter an options position you are far better off picking a range in time or price as your exit signal rather than waiting for confirmation as you would with blue chip shares, simply because it could cost you lots of money.
For example, if I was trading Newscorp options I know (from back testing the stock and my trading plan) for the most part when I get an entry I am pretty safe holding onto the option for three days and that I should achieve a good price movement during that time. Therefore I would be looking to exit at the beginning or end of day three depending on how strong the market was at the time.
So where do you put a stop loss on an option? This is a pretty common question and one that I have heard lots of answers to. But the best one in my book is that if after entering the option it turns against you, then you should exit. The reason for this is that in options if you get a trade wrong you will, for the most part, lose 50%, therefore you need to limit the loss as much as possible.
Futures are different again; although they are highly leveraged they are less volatile than options and have less of a spread in the price between buyers and sellers. Therefore you need to select rules and stop losses that are appropriate to trading this market.
No matter what market you decide to trade, the most important aspect to your success in the share market is to prove to yourself that your trading plan works by back testing it. Any deficiencies in your plan will dramatically increase your probability of losing. As traders you also need to be aware of your win/loss ratio (how many times you win against how many times you lose) and your profit/loss ratio (how much we win against how much we lose) as this indicator alerts you to whether or not you are profitable. Once you understand these figures you then need to work on improving them so that you can become more profitable.
In my experience the first place traders should be looking to increase these ratios is their trading plan and the exit strategies they use. In reality, however, most traders continue scanning the market for the next biggest and best trade in the hope of increasing their profitability, which as I have mentioned can be their greatest downfall. Remember, the elite in anything are just that because they spend more time fine tuning their skill level and practicing their techniques, not because they just happen to show up on the day.
Let me say, if you decide to heed the practicality of the information in this article then you will become a very profitable trader. If, however, you decide to enter an investment without a good exit strategy then you are gambling. And unfortunately gamblers always lose. Consistently successful traders, on the other hand, are risk managers not gamblers.
