What’s the most important part of any trade? The exit, of course. The exit price of a trade ultimately determines whether the trade is a winner or a loser, after all. But where do traders tend to focus most of their efforts? On trade entry! So for this blog post, let’s focus on this ever-so important part of every trade: the exit.
The Exit-Strategy Premise
First, we need to set a few things straight. You’ll have winners and you’ll have losers. That’s just how the game is played. No matter how good you are, you never really know how the trade is going to work out until it’s all said and done.
Second, no one can be a successful trader without a plan. Winging it doesn’t work. Once you commit to making a trade, you need a plan in place that includes not just where to get in, but also where to get out.
Therefore, each exit strategy needs to have two potential exit points: one to exit the trade for a profit, and one to exit to take a loss.
Imagine a trader buys a one-month call for 5.00 on a stock he thinks will rise in the short term. Whatever the chart says, whatever the fundamentals say, whatever the trader’s mother-in-law says about the trade, he doesn’t know for sure whether the trade will work out or not. The trader must plan both for success and for failure.
Conventional wisdom dictates let your profits run and take your losses quickly. Because calls have an inherent leverage component, the trader must seek higher percentage gains and accept higher percentage losses than he would if he was just buying the stock. A reasonable profit to shoot for on an aggressive play might be 60 to 80 percent (Though, to be fair, that is an arbitrary figure. In reality the target would be based on situational circumstances and the trader’s risk tolerance, etc.). A reasonable loss exit point may be 30 percent lower or so (Same rationale as profit target). So the trader in this example would plan the following exit points:
- Take profits if the call reaches 8.00
- Take a loss if the call reaches 3.50
Psychology and Planning
The real benefit of planning is that it takes the emotional element out of trading. The trader in the example could very easily see his call trading 8.00 and think “Maybe I’ll just hold off for 9.00” and subsequently see the market turn and lose his would-be profit. Or, he could see it at 3.50 and think “Maybe it’ll come back” and watch the call value fall even more. Don’t tell me this hasn’t happened to you!
Exit commitments are very important for trader discipline and the ultimate success of all traders. Next time you’re setting up a trade, make sure you put effort into the exit plan. It is, after all, the most important part of the trade.
Dan Passarelli is the President and CEO of Market Taker Mentoring LLC, http://markettaker.com.