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?
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.
|Use the fundamentals||By monitoring and assessing an investment, you can continuously evaluate whether it’s a trade that still aligns with your objectives and risk tolerance. For example, if you bought a stock because it declined in price to a level where you thought it was attractively priced, you can evaluate it at any time using new financial data, company news, price multiples, and other fundamentals.|
|Support and resistance||A support level is a price where chart users think there could be buyers to prevent the price from going lower. Traders with a short-term time frame sometimes consider placing sell orders at or just below support levels to sell long positions if they think the price will go below the support level to prevent losses (if the purchase price was above the support level) or lock in profits (if the purchase price was below the support level). A resistance level is a price where chart users think there could be sellers to prevent the price from going higher. Traders with a short-term time frame sometimes consider placing sell orders at resistance levels to sell long positions if they think the price will hit a resistance level.|
|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. What you do once you've arrived at that time is up to you, but 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.
|Market order||This is the fastest way to exit an investment. This order’s execution is guaranteed, but the price is not.|
|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.|
|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. Because a limit order sets the lowest price you’re willing to sell at, price gaps become easier to avoid. But remember, execution on limit orders is not guaranteed, so there is a chance the security may never reach your limit price.|
|Conditional order||Placing a one-cancels-the-other order, 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 and limit your losses all with one order. There's even a way to use conditional orders to set your bracket before you enter the trade. This is known as a one-triggers-a-one-cancels-the-other order. These may sound complicated, but Fidelity has a tool called Trade Armor® that makes both of these conditional orders easy.|
If you're not ready to place an actual order to plan your exit, at least consider setting a price trigger alert or making a note to document your 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?