Learn more about:
- The importance of planning both an entry and exit strategy
- Things to consider when entering or exiting a trade
- Ways and tools to help build a plan for the trade
Preparing to place a trade
At this point in your trading plan, it’s important to simultaneously think about why, how, where, and when you should enter and exit a trade.
Evaluating both ends of the trade can help manage risk and maintain a disciplined trading strategy.
Let's begin with more about initiating a trade.
Why should you have an entry strategy?
An entry strategy is a plan for how you’ll get into a position. Good traders value efficiency. They’re constantly looking for ways to maximize returns and manage risk. This is why having an entry strategy is important—it can help you more efficiently use the money in your account.
Why should you have an exit strategy?
Exit strategies are one of the most important yet overlooked parts of trading. 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 to have a plan for getting out of a trade.
Ask yourself 3 questions
Before you place a trade, take a moment to think about why you’re considering it—make sure it’s for the right reasons and try not to let emotions play a role. Then, ask yourself these questions as a starting point to help evaluate your risk tolerance.
- What’s your time horizon? Knowing how long you’ll be in the trade can help you better decide your entry and exit points. The longer your time horizon, the more flexible you can be.
- How much risk can you afford to take on a particular trade? Make sure you’re comfortable with the size of the trade based on your overall portfolio value.
- Does this trade align with your strategy? Don’t feel like you need to jump into a trade if it doesn’t fit your trading strategy—keep looking for the right opportunity.
Indicators can help plan your entry
There are many indicators to focus on, but you have to determine which ones may work for you. Here are a few examples to consider before entering a trade:
- Are there any upcoming events that could cause the stock to move in one direction or another? For example, depending on your risk tolerance, if the stock is expected to announce earnings the next day you may consider holding off on the trade, as an earnings report could drive the price in one direction or another.
- What are analysts saying? Have they rated this a buy, a hold, or a sell?
- Are there technical indicators that indicate bearish or bullish sentiment?
Here's a tip; create a watch list for the stocks you’re interested in. That will make it easy to see news headlines, and dividends and earnings announcements at a glance. You can also set price alerts so you're proactively notified when a stock hits a target price you're interested in.
Building a sound exit strategy
Once you’ve decided to buy a particular security, there are several ways to plan your exit strategy. Let’s review 2 common ways, target profit/loss ratio and the 1% rule.
A target profit/loss ratio allows you to set profit and loss targets from a purchase price. For example, one option is to use a target profit/loss ratio to set profit and loss targets from a purchase price. This can help you plan the points at which to limit your downside exposure, while setting a target on your upside. For example, if you’ve decided that the maximum you’re willing to lose is $300 and that the minimum profit/loss ratio you’re comfortable with is 3:1, then you should be targeting a trade that has a $900 profit target.
The 1% rule is a general rule of thumb that suggests investors should set their max loss at 1% of their liquid net worth. For example, if you have $50,000 in savings, you shouldn’t be willing to lose more than $500 on any one position.
Using support and resistance
Another tool you can use when planning for a trade is to look at points of support and resistance—2 key technical indicators that can be good barometers of when to buy or sell.
Support occurs when a security bounces off a series of lows in price. Basically, it's the level at which demand for a security is strong enough to stop the security from falling any further. However, once a security breaks a support level, it could mean further downside pressure. That’s why many traders place stop orders just below points of support to help protect themselves from additional losses.
Resistance is the opposite of support—when a security bounces off a series of highs. Here, the supply is strong enough to stop the security from moving any higher. When a security struggles to break through resistance, it might be time to think about getting out and taking your potential profits.
Why are order types important?
There are many different orders types: market, limit, and stop loss order, to name a few. These simple, yet powerful, tools can help you manage your risk and more effectively implement your strategy.
Understanding the differences between order types can help you to better ensure a trade is executed in a timely manner, at a price you’re comfortable with, and reduce potential risk.
Being smart about your order type is just another way to manage emotions and bring discipline to your trading. We’ll dig deeper into order types in the next lesson.
A tool that can help
As you prepare to place a trade, Fidelity's Trade Armor® can help you to initiate and manage your entry and exit strategies. With a range of functionality to place trades, along with charts, news, research, and position data, you can easily:
- View support and resistance on a chart
- Use a variety of different order types
- Keep an eye on news or analyst opinions
- We'll show you more about how to use this tool in the next challenge.
- It's always important to have both an entry and exit strategy before placing a trade. Evaluating both ends of the trade can help manage risk and maintain a disciplined trading strategy.
- Support and resistance are key technical levels that can offer insight into a stock’s strength at a given time.
- Understanding different order types can help to save you time, money, and reduce potential risk.