Knowing when, or even how, to exit a trade is one of the hardest aspects of trading.
It can be hard to admit defeat on a losing trade, and sometimes even harder to take your profits and call it a day on a winning trade.
This is why having a clearly defined exit strategy is critical. It could save you from giving back your gains or losing more than you intended to. Here are a couple of tips for exiting a trade.
The idea of scaling out of a position is to leave yourself the flexibility to adapt to swings in the market. For example, if you’ve got a 1,000 share position and the value of the stock doubles, scaling down might entail selling half your shares.
Essentially, you’re now playing with just your profits. This gives you the assurance that you won’t lose money on the trade, while also maintaining your exposure to the stock to capture more potential upside.
Another exit strategy tool that can be helpful is a hard stop. A hard stop is akin to placing a stop order at a specific price. For a long trade, hard stops are placed below the price you bought in at, and vice versa for shorts.
The benefit of hard stops is, depending on where you place it, it will protect you from potentially catastrophic losses. There is, however, a downside to using a hard stop, and that is you leave yourself vulnerable to gaps.
It’s not uncommon for stocks to gap during the overnight/premarket trading session, and open dramatically higher or lower than where they closed. When this happens your stop may be filled at a lower price, thereby costing you more than you intended.
Stop orders are typically converted into market orders when they are triggered, meaning once the stop price is reached, your order will be filled at whatever the market price is.
But you can also place a stop-limit order, which is triggered like a regular stop order but only executes at a specific price.
So for example, if a stock is trading at $55.10 and you have a stop order at $55, once the stock falls below that price, you’re going to get filled regardless if it falls to $54.90 or $50.
But with a stop-limit, you could essentially say “I want to sell 100 shares of stock XYZ once it falls below $55, but only if stays above $54.” In this case the $55 price is the stop or trigger price and the $54 price is your limit price. The stop-limit gives you a little more precision in how you exit the trade. It is important to note that with the stop limit order it is possible that your order may not be executed, since there is a limit price component. In the example above, if the stock closed the previous day at $55.50 and opens the day at $53.00, the stop price ($55) will trigger the stop limit order, but since the limit price is $54, your order will not be executed until the stock price trades at your limit price.
Regardless of how you do it, the most important part of a good exit strategy is having an idea of how you will close a trade before you open it in the first place. It’s easy to make calm, calculated, rational decisions when no money is at risk. But once you have taken that position and it starts to move, it’s easy to make an emotional decision that can get you in trouble if you don’t already have an exit strategy in place.
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