Exit Strategies Are Designed to Protect Your Value
Rule #7 – Have an Exit Plan and Target for Every Stock
Few experienced traders ever invest in any stock without having an exit strategy. In its simplest form, an exit strategy is a plan to get you out of something you’re in. In the investment universe, it means you should have an exit plan for each investment, before you enter into that investment. Understand what you’re trying to accomplish, set limits on market values to define your accomplishments (on both the upside and the downside), and have an action plan that allows you to exit successfully.
Three primary considerations typically dictate your exit strategy development:
- 1. How long do you plan to own the security? You should have an idea of the time period you want to own the investment. It matters little whether you favor a short- or long-term duration. The choice is yours. Also, should circumstances change during your hold period, you can always modify your original plan and shorter/lengthen the ownership target period.
- 2. What level of risk do you plan to endure? Zero risk would be wonderful, but that’s impossible. Decide how much risk you feel comfortable to take with a stock. This can appear to be a moving target, but you’ll feel more comfortable in setting a risk parameter. Even if you’re wrong, addressing this issue will help your eventual success rate. How much are you “willing” to lose on this investment? That is your risk level.
- 3. At what price do you want to exit? This component is both the easiest and, sometimes, the most troubling component of your exit strategy. You’ll invariably find that you ask yourself:
“Should I wait until the price goes higher than my original exit target?”
“Maybe I should hold the stock a bit longer, even though it’s decreased to my exit target, to give it a chance to recover?”
In most cases, if you’ve developed a thoughtful, fact-based exit strategy, you should resist the temptation to change your plan. Of course, if factual events occur that indicate a strategy change, make it to protect your portfolio.
Protecting your values should be at the top of your exit strategy checklist. A good exit strategy is faithful to Rule #1: Ride your winners and cut your losers. Here are a couple of popular options to achieve these goals:
- Stop-Loss Orders (Stops) (S/L): These are common components of many exit strategies. Stops encompass orders you can give your broker that direct him/her to sell a security at a pre-determined price. When your price point is reached, your stop becomes a market order to be executed right away.Stop-Loss Orders are an excellent tool to protect your values. By setting high and low price points, you are “programming” your profit and capping your losses.
- Trailing Stop (T/S) Orders: A modification of an S/L is the Trailing Stop Order. You set a “distance” between the market price and your Stop Order. While you don’t want this order to move downward on the loss side (you could only increase your losses), it can be useful on the upside. For example, assume you place a Stop-Loss Order on a stock that you bought for $85 for when it reaches $135. But, suppose it projects to go even higher? You might lose further profits. You decide to issue a Trailing Stop stating that your S/L should be $20 below current market price.As long as the price of your security keeps moving upward, your T/S will trail (follow) its rise in value. Once your stock begins to fall, your T/S Order will become a market order to sell when the stock’s market price falls $20 below its peak. Once again, you have protected your values quite effectively.