Traders tend to focus too much on fine-tuning their entry rules and choosing between stocks. Picking the right exit can be just as important, if not more important, than picking the right entry. After all, it is the exit that locks in your profit (or loss) and ultimately impacts the equity in your trading account.
Traders have different methods for closing trades and the type of exit normally depends on the type of trading strategy used. This post is all about the techniques used to exit positions, rather than the signs that tell you when to sell. Here are 10 different ways to exit a trade:
10 Ways to Exit a Trade
#1 – Fixed-risk stop-loss
The fixed-risk stop-loss is where you decide beforehand how much you can afford to lose and place a stop-loss in the market corresponding to that amount.
This is one of the worst ways to exit a trade. Too often, traders neglect to test the effectiveness of stop-loss levels and end up using any arbitrary number. Traders might place a stop 10% away from the market, but why 10%? Why not 9.8% or 10.1%?
The major problem with the fixed-risk stop-loss is that it does not reflect the dynamics of the market and is not related to the reason for placing the trade in the first place. The difficulty is that stocks fluctuate wildly. They often take out stops then reverse back the other way, ending up more-or-less where they were before. This type of stop is probably best reserved as a worst-case scenario stop, for protection against truly rare events.
#2 – Reverse entry rule
One method of exiting a trade and one that makes a great deal of sense is to simply exit when your entry rules have reversed.
For example, if you bought a stock because it just hit a new 50 day high, you should probably sell it when it hits a new 50 day low, if not before.
Likewise, if you bought a stock because you calculated it was cheap, you should sell it once you’ve calculated it’s no longer cheap.
#3 – Price action stops
Trend line stops are good for traders who look at naked price action. Since price action patterns are highly discretionary it makes sense to have a relatively discretionary stop-loss level too.
Strong up-trends feature successive higher highs and higher lows and that gives a great opportunity to draw an upward trend line connecting the lows. Having a stop a little below this line can be a good way to manually lock in profit and keep risk tight.
Similarly, support levels and resistance levels, once drawn on a chart, can be used to place stops in areas that give the best risk/reward.
#4 – Trailing stop
Trailing stops track a stock price as it moves higher or lower, thereby locking in profits and reducing risk. In the case of a long trade, a trailing stop can be attached to each new high and this will move up as the stock price climbs. This can be designated by percentage amount or in points.
For example, a 35% trailing stop allows a stock to keep moving higher and higher, but the moment it drops 35% from it’s highest high, the stop will kick in and the position will be closed. Trailing stops are useful for trend followers as they abide by the golden rule of letting winners run and cutting losers short.
#5 – Chandelier stop
The Chandelier stop is essentially a trailing stop which uses the ATR (Average True Range) instead of using an arbitrary percentage or point value.
In other words, instead of placing a stop loss 20% or 20 points below the market, you place the stop whatever the ATR is. Traders normally use an ATR(14) and a multiplier so if ATR(14) is 30 and the multiplier is 4, the trailing stop will be placed 30 * 4 points away.
The major benefit of the Chandelier stop is that it adjusts to volatility, allowing volatile stocks more room than less volatile stocks. It’s another good exit for trend followers.
Following is the Amibroker code for the Chandelier stop as described above:
#6 – Profit target
Profit targets are best used for mean reversion trading systems and short-term strategies. The problem with using a profit target is that it’s all too easy to limit your potential gains. Profit targets do not work when following trends since the whole principle behind trend following is to let your winners run, and you can never know how long a trend will continue for.
Profit targets do not tend to do well in back-testing either. But they may be useful for day traders who have a strong relationship with the market they trade.
#7 – Fair value
Investors who have a strong grasp of fundamental value can calculate what they think is the fair value price of a stock and then exit whenever the stock price meets, or moves beyond that level. This is not an easy task since the value of a company will change as it’s stock price changes (relativity). All sorts of factors like investor sentiment will also have an impact.
One simple method is to watch the Peter Lynch value line. Whenever a stock is below this line, it’s said to be undervalued and whenever it’s above, it’s said to be overvalued.
#8 – Time-based exit
Using a time-based exit can be a useful one for traders since markets observe different patterns depending on the time of day, week, month or year.
For example, stock market volume picks up during the US session then dies down after hours. Some day trading strategies are therefore designed to capture moves in the after hours market and trades are closed as soon as the market re-opens.
Similarly, since companies release earnings once every three months, some strategies seem to do well with three-month holding periods.
Quantpedia has a good selection of strategies like these where time-based exits are used to good effect.
#9 – Top slicing
UK small cap expert Simon Thompson is known for making value plays and he often advocates a technique known as top slicing. Top slicing is where you have a nice winning position in a stock but have spotted a new opportunity elsewhere.
The technique involves closing two-thirds of the trade and attaching a 10% trailing stop to the rest. This ensures you have some money left in play, in case the stock keeps going higher, but it also liquidates some capital which you can put into a new investment.
#10 – Never
Warren Buffet, the world’s greatest investor takes a fairly unique approach to exiting his stock trades. Buffett famously said that “when we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever.”
It just goes to show that when you pick the right stock in the first place, your precise exit point becomes less of an issue – a great position to be in.`
# The No.1 Worst Way To Exit A Trade – through emotion – hope, greed, wishful thinking, fear, gut-feel.
As you might have predicted, there are numerous ways to exit a trade. As usual, it pays to take a quantitative approach where possible and test which types of exits, and which values, work the best for your own trading strategy and personality.