Understanding Exits: Helpful Advice on Exit Strategies

Exit strategies for investors and traders are a much neglected subject. There are thousands of books that attempt to teach us about what and when to buy but I can count the books about selling on one hand and have a few fingers left over.

My fascination with the subject of exit strategies probably came about due to my very first “investment” in 1963. As a young college student I bought a contract of corn futures that was expected to expire in less than a month. Buy and hold was not an option in the commodities markets, so my immediate problem to solve was when to sell my 5,000 bushels of December Corn.

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One of my college professors had taught me the strategy I had used to buy the corn contract. But when I sought his advice on when to sell it, he shrugged, smiled and told me I was on my own, but to be sure to sell it before it was delivered to me. I sold the corn contract a few days later simply because I had quickly made about a month’s wages (I wasn’t paid much) and I needed the money. After making a profit on my first investment, I’ve been trading and trying to figure out when to sell financial instruments ever since.

After more than 40 years of trading, I’ve managed to learn quite a bit more about selling in spite of not having had much help or good advice along the way. Apparently, my college professor was not the only one who wasn’t clear about when to sell. I suspect that many of those reading this article are also looking for help, so I will briefly share some basic thoughts about what I have learned over my many years of focusing my attention on exit strategies.

Investment and trading results depend on exits – not entries. Everyone needs to realize that our exit strategies determine the outcome of our trades. Our exits directly control our profits and our losses so they deserve our full attention and effort. If you are reading this article – that’s a good start. Try to find even more information about when to sell. (It’s not easy. Good luck!)

When David Lucas and I were doing our research for our book Computer Analysis of the Futures Market, we were involved in testing a large number of popular technical indicators to see which ones produced the best trading results. It didn’t take us long to discover that the results of the indicators, used for entry signals, depended entirely on what exit strategy we paired them with. Based on our testing results it was obvious that the exits were more important than the entries. After some careful thought, our solution to the entry testing problem was simply: to exit every trade after a fixed period of time and to use the same period of time to compare the various entry methods. If we used any other exit method it had too much influence on our test results.

Don’t default to Buy and Hold. Define risk and limit your risk. Attention to exits is important because it is our exit strategies that allow us to define and control risk. Without an exit strategy, risk remains undefined and uncontrolled. If you buy a thousand shares of stock at $50, what is your risk? If you don’t have a black and white exit strategy that tells you where to sell, your risk defaults to being 100% of your investment (and even more if you are leveraged). That amount of risk should never be acceptable but that is exactly what most uninformed investors are doing. Those investors who rely on Buy and Hold (or who have no exit strategy) should realize that they are using the most risky exit strategy ever conceived. The risk of Buy and Hold is completely undefined, uncontrolled and limited only by the amount of capital on the table. Buy and Hold ignores the fact that risk control is perhaps the most important problem in all of investing.

Rather than to solve this critical risk problem directly by employing a well thought out exit strategy, the advocates of Buy and Hold, resort to all sorts of creative but often complex measures involving carefully weighted diversification, asset allocation models, correlation studies, portfolio balancing and rebalancing and so on. It keeps a lot of “quants” busy designing and monitoring these sophisticated strategies simply so they can avoid getting wiped out by their steadfast commitment to Buy and Hold.

Why can’t they simply keep their winners and sell their losers? Is that so difficult? Rather than adopting an intelligent exit strategy, in the first place, all of this extra effort is devoted to making a basically unintelligent and unlimited risk strategy less risky. In my opinion that is a serious waste of intellectual talent. But if you default to Buy and Hold as your exit plan, you will need all of the best intellectual help you can find to lessen the risk. (And then pray you don’t run into a bear market just before you need to cash out.)

Let’s make sure we control what we have the power to control. Unlike profits we have direct control of the size of our losses so why not make the effort to control those things that we know we do have the power to control. Unfortunately, profits are mostly beyond our control. If we go back to that earlier example of the stock we bought at $50; how do we make sure it goes to at least $100? I’m sorry but I can’t help you with that. It simply can’t be done. But I can help you to make sure you don’t own it when it goes down below $40. That’s easy. Just be sure to sell it at about $41. Controlling losses is easy but controlling profits is impossible. Let’s not worry so much about the size of profits we have yet to see and focus more on carefully limiting losses that we can and do see and then taking profits in a timely fashion once they materialize.

Many knowledgeable and professional investors control risk very precisely by a procedure commonly known as money management or more accurately “position sizing”. However, in order to accurately decide the size of the position to buy, we first have to know where we will exit if we are wrong so that we can calculate our risk. Example: We are going to buy our stock at $50 a share and we know that our account size is $100,000. We want to limit our risk to a maximum of 2% of our capital or $2,000. Our exit point on the trade will be $40 so we are risking $10 per share. We then divide our $2,000 maximum risk amount by the $10 per share that we are risking and we know that our correct position size is 200 shares.

Once we know our exit point we know our risk on that position and it’s a simple calculation to buy the correct number of shares that will prudently limit our risk to 1% or 2% or any % of our capital. This logical and very helpful process of accurate position sizing to limit risk exposure is not available to Buy and Holders because they don’t know where their exit will be, therefore they have no way to calculate their risk or to calculate their appropriate position size.

The purpose of this article was to help you understand that exits are critically important to investors and traders of all shapes and sizes and to voice my strong opinion that Buy and Hold is not an acceptable exit strategy. If you are interested we will have future articles about some specific technical strategies. In the meantime you are invited to visit www.SmartStops.net for more information and some very valuable help on when to exit stock positions.

Charles LeBeau is director of quantitative analytics at SmartStops.net and co-author of Computer Analysis of the Futures Markets (McGraw-Hill). For more of Chuck’s commentary, visit www.smartstops.net

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