Mastering The Art Of Exiting A Trade
Several years ago when
I was teaching a trading workshop, I spelled out technical and fundamental
reasons to buy Dell Computer
(
DELL |
Quote |
Chart |
News |
PowerRating). The
next day, the market dynamics changed and what I had been saying about Dell was
no longer valid, so it was not a trade I would have entered.
About two months later, one of my workshop
students (who happened to be a doctor) e-mailed me, wanting my reasons for
having abandoned Dell. She claimed that if she had bought Dell at the time of my
workshop rather than later, she would have been positive on the trade, not in
the red as she now was. When I asked if she
had a place in mind to exit the trade, she replied, “Yes, 10% below my
purchase point.” I asked how far Dell had fallen below her purchase price.
She said 24%. “Why did you break your sell rule?” I asked. She
replied, “I refuse to accept losses.”
After looking at her account statements, I
noticed a couple of stocks she had purchased had sizable gains: 56% and 34%. She
told me she hadn’t sold them because she didn’t like
paying taxes. Every day, this successful emergency surgeon had people’s
lives in her hands, yet she was unable to sell a stock, regardless of whether it
was up, down, or unchanged. My student had unintentionally become a long-term
investor instead of a trader. I, too, have
agonized over exiting trades until I finally got it through my thick head that I
needed to throw out my ego and stick to my
profit-and-loss rules.
No
Pain, No GainÂ
We learn associate situations or actions with
pleasure or pain. When we go into a trade, be it long or short, call or put, we
do it with optimism, in the hopes of great things like the possibility of profits
— or a boost to the ego for being right. When the trade works out in our favor,
it is pleasurable. Now for the pain: We avoid it at all costs. If a trade does
not work out, what do you tend to do? Often, people hang on in hopes that the
trade will reverse and go the opposite direction. Some people have a hard time
exiting because they don’t want to take a loss or be proven wrong. Often, it has
more to do with the latter. The ego wins again!
Often, because of the emotion involved in exiting
a winning or losing trade, exiting a trade is not easy. Exiting
a trade, whether price is up or down, is seemingly always stressful. Even when
we do sell at a nice profit, there’s that nagging fear that we’re probably
making a mistake; that we surely can’t possibly be totally right. “This
stock could go higher.” And of course, selling a stock when it’s
down occurs either in times of widespread fear and panic, or at a moment of
personal resignation to loss, or admission that we were not as smart or lucky as
we’d thought.
Don’t Be Influenced By
Others
When it comes to trading, people can easily be
influenced by what others are saying. I’m amazed at what sheep we can be.
Exiting trades is made even more complex by the daily
conditioning we unwittingly receive from the news media. One morning, our
favorite business news anchor will tell us the market could rise because
investors are impressed by strong economic indicators. That very afternoon,
another reporter will say that the market is falling because investors fear that
strong growth will cause the Federal Reserve Bank to raise interest rates. We
sit there and bob our heads approvingly at both versions. We should all
understand by now that the media’s first function is to confirm existing
prejudice, rather than contradict it. We hear over and over how strong the
economy is — or how badly things are going. All this reinforcement helps us to
believe in current trends, causing us to dismiss other scenarios.
Another external obstruction to selling —
because it makes clear thought more difficult — is information
overload. With the Internet and all of its chat-rooms, message boards and
news services, these wonderful information hubs can be a double-edged sword. Exiting
a trade requires an investor to deal successfully with indecision, and that it
is always difficult and stressful. This problem operates at two levels:
The owner of a stock has formed a positive set of
images and expectations. Exiting requires processing new, negative or positive
information and accepting its importance to the extent that one can internalize
(and then act on) a 180-degree reversal of one’s prior thinking. Selling often
also requires putting aside contrary current positive factors. Yesterday, this
was a great company with sound prospects, selling at a reasonable price, which
the investor was brilliant enough to have bought and held through thick and thin
to today’s higher prices. To sell today, he or she must suddenly believe the
company to be less attractive. In order to exit now, one
must usually concede being wrong. This is a
challenge loaded with emotional difficulty.
Making Better Exit Decisions
Is there a simple cure for the ingrained and
self-destructive aversion to exiting a trade? Perhaps two practices can help
battle those forces that make exiting trades difficult. Both, not surprisingly,
require the exercise of self-discipline.
First, before a position is entered long or short
(this goes for options also), a clear selling-price target should be established
on the basis of three interacting factors:
- Price
target: Where is the trend of the stock
going? You need to see where support and resistance is and if volume
is supporting an explosive move to the upside, or if volume is drying up and
the stock looks to be pulling back. Every day on the TradersWire,
our War Room analysts are pointing out potential setups. - Scenario:
What type of strategy are you using? Are
you using spreads for options? Are you trading a “Slim Jim” or
“Trap Door”? These strategies all have scenarios and one of the
deadliest things that a trader can do is get into a trade because it looks
good to them, but there really isn’t anything supporting their finding — or
because an analyst put a strong buy on it. - Time
frame: What type of trader are you?
Your time frame can be a couple of minutes, hours or days. For example, suppose
you are a swing trader and you hold positions for a couple of days to a
couple of weeks. Let’s say you enter a long trade on Microsoft
(
MSFT |
Quote |
Chart |
News |
PowerRating) at 54.00 and your goal is to make $2.00. After you entered the
trade, within two hours Microsoft has rallied up to 56.00. Are going to take
the profit? Or are you going to wait to see if you can make more money?
Before entering the trade, ask yourself these
questions. If all three elements are not present, a trade position will leave
your money floating aimlessly with no means of evaluating success or failure.
At the slightest temptation to change the rules,
sit yourself down and take extensive notes on your exiting vs. hold behavior.
Everyone has one or more recurring sell/hold behavior patterns. Becoming aware
of these (a checklist on every trade is suggested) will help you to side-step
those self-created potholes that keep you holding, when you really ought to be
exiting a trade.
- One practical discipline overcomes several of
these self-defeating tendencies: Place a sell order at
the target price immediately when the stock is purchased.  - Second, apply this critical test to each
holding (and I recommend that this be done frequently): Looking at today’s
price, knowing what you know now, ask yourself, “If
I had extra cash and it would not violate my portfolio balance, would I buy
this stock right now at its current price?” If you would not,
the logical conclusion is that it should not be retained in your portfolio.
What you would not buy at the current price, you should not hold (holding
being just reinvestment for another day), so that stock must be sold. This
is a harsh but valid discipline.
Clearly, with all the difficulties surrounding
exiting trades, any new disciplines or aids to overcoming the real and
psychological problems investors face in this area should be of great value.