Why should you have an exit strategy?
Successful traders know that their greatest enemy can be their own minds. Often, emotions and loss aversion can get in the way of making good trading decisions. That’s why it's so important that you have a plan for getting out of an investment.
You should consider these questions before getting into a trade:
- How long do you intend to be in the investment?
- What will you be using to measure performance?
- How will you know when it’s time to get out?
- What order type will I use to carry out my exit strategy?
Having an exit strategy is essential in managing your portfolio because it can help you take your profits and stop your losses. Exit strategies are important whether you’re an active trader or a passive investor.
4 common ways to build a sound exit strategy
Even before you enter a trade, it can be helpful to have a plan for how you might exit the trade. After doing your research and getting into a trade, here are a few ways to plan your exit.
| Strategy | Description |
|---|---|
| Use the fundamentals | You might buy an asset because it declined in price to a level where you thought it was attractively priced fundamentally. You can continue to evaluate it using new financial data, company news, price multiples, and other fundamentals. By monitoring and assessing an investment, you can continuously evaluate whether it’s an investment that still aligns with your objectives and risk tolerance. Fundamental-based strategies tend to be longer term investment strategies. |
| Use technical analysis | Technical analysis is the study of price action through supply and demand to determine entries and exits. Utilizing trend (prior price direction) and/or support and resistance lines (horizontal areas of historical shifting from buyers to sellers and sellers to buyers), you can place orders to exit a trade if certain conditions are met. Technical analysis can also utilize common price patterns and technical indicators that measure price action to create a strategy. |
| Target profit/loss ratio | You can set profit and loss targets from a purchase price. For example, a rule could be a 2:1 or 3:1 profit/loss target. You can also use percentage terms, such as 10% profit/5% loss target or if you want something with a tighter stop, a 9% profit/3% loss target. |
| Time exit strategy | Defines the maximum amount of time you plan on being exposed to a particular investment. Most traders use their time exit signal as an indicator that they should, at the very least, re-evaluate their investment. Time exit strategies can work when the security is moving sideways for an extended period of time, when prices are moving against you but not enough to trigger a stop-loss (an order that triggers at a specific price which executes at the next available price), or when it's moving up too slowly for your liking. |
Using orders to set your exit strategy
There are many different methods for exiting an investment. Here are a few of the more common ones.
| Order type | Description |
|---|---|
| Market order | This is the fastest way to exit an investment. This order’s execution is guaranteed, but the price is not. We want to avoid letting our emotions dictate the trade, so you might utilize alerts at certain prices to send an email, text, or pop-up in Active Trader Pro®. Once you receive the alert, the decision of whether to exit the trade can be made. |
| Limit order | Sets the minimum price at which you're willing to sell an investment. Essentially, you're saying "I want to sell X shares if the price reaches $Y." This order is not guaranteed to be filled (because your price limit may never be reached), but the price it executes at is guaranteed. |
| Stop loss order | Allows you to place a target price on the downside that you wish to sell at. When that price hits, your order converts to a market order and you’ll trade at the next available price. Beware: Stop orders will not protect you from sudden price drops, known as gaps. A Trailing stop loss/limit order automatically adjusts the exit trigger price when the actual price of the investment moves in your favor. You can set the trail of your trigger price based on a dollar amount or percentage away from price. The benefit to this order is that it creates a “high-water mark” for your exit, automatically moving your order to possibly lock in gains or reduce possible losses. |
| Stop limit order | Acts very similar to a stop loss. It's different in that it sends a limit order rather than a market order to execute your trade once a trigger price is reached. But remember, execution on limit orders is not guaranteed, so there is a chance the security may never reach your limit price and execute the order. |
| Conditional order | Placing a one-cancels-the-other order (OCO), or what is also commonly referred to as a bracket order, allows you to have both a limit order and a stop order open at the same time. This allows you to lock in your potential profits if a limit is reached and stop your losses if the stop is triggered all with one order. When one order is filled, the other is canceled. This order is often used with the Target Profit/Loss strategy. |
Planning your exit is one of the most critical parts of due diligence on an investment. A sound exit strategy can help you take profits, minimize your risk, and control your emotions. And who doesn’t like taking profits?