Stock tips are, more often than not, based on entry points.
You find a commodity that looks promising, you decide to invest, and you buy in. If you’re a passive investor, you intend to hold onto the stock and watch the profits grow. If you’re more active, you intend to hold onto the stock for a short time.
But knowing when to exit a stock position is at least as crucial as knowing when to buy — more so, in fact.
A stock exit strategy is important for both classes of investors. Short-term traders need to plan their exit points on a daily or weekly basis. But passive investors also need to spend some time to make trading exit strategies.
Trading Exit Strategies: Why They’re Important
The goal of every investor is to keep a portfolio that turns a profit. There are many ways to do that: Studying the structure of the stock market, diversifying holdings, setting investment goals, and so forth.
The stock exit strategy is a key element in basic portfolio health. It serves to keep your holdings balanced, taking profits at the right points and preventing losses from becoming too steep.
Day trading exit strategies are part of the game. Active investors build their entire careers around finding the right exit points on short-term holdings.
But passive investors, in general, pay far less attention to stock exit strategies. They tend toward “buy and hold” commodities that they expect to turn profits over long periods of time. Sometimes, there’s even an emotional component to the decision. They grow attached to certain long-term holdings and don’t “feel” right about cashing in on blue-chip stocks that may have hit their plateau.
Before anyone enters into the stock market, whether they buy one position or 30, they need to have some basic trading exit strategies in place. Whether it’s based on an optimal selling price, cutting losses, time in a position, or diversifying your holdings, a smart stock exit strategy is a strong maintenance tool.
Here are some common long-term and day trading exit strategies and tips on setting them up.
Stop-Loss Limits
Very few stock portfolios are 100% profitable. Every investor’s list of holdings contains stocks that win and stocks that lose.
At least for passive investors, it doesn’t make sense to give up on a stock the second it dips into the red. It could be losing because of a temporary downturn in the market. Or it may be going through some industry shakeups that the company will eventually work through. It could even be a seasonal issue — a company that sells winter coats may find its stock flatlining or dipping in June but heading back up in November.
But at some point, enough’s enough. When a stock keeps declining in value, it may take a considerable time for it to return to profitability. It’s then advisable to cut your losses by setting a stop-loss limit.
A stop-loss limit is exactly what it sounds like: A point below the price you paid for a stock at which you sell it. For example, say that you’ve bought multiple shares of a growth stock at $25 each. You can place an order in which you tell your broker to sell the stock the minute it hits $20 a share. When it does, the limit order turns into a market order, and your stock is then sold.
Stop-loss orders are easy to execute on online brokerage sites. If you use the rare brokerage that still charges commission on transactions, you’re not charged until the stock is sold.
Methods for Setting Stop-Loss Limits
Determining your stop-loss limit is largely tied to what kind of investor you are and how much risk you can tolerate. Many simply choose a limit based on loss percentage: Once share prices dip to between 10% or 25% less than what they paid for them, they sell their shares. If you’re someone who gets skittish about erratic stock prices, you could even set a stop-loss at a single-digit percentage.
One method that investors use to set stop-loss limits is to base them on patterns of support. These are points in a stock’s price history when the price was low enough for investors to buy in, causing prices to rise again. The stop-loss limit is then revised as the stock keeps increasing in value over the long term.
For example, say that a share’s price dipped to $30, causing a surge in buying activity, which then moved the price up to $40. That $30 price indicates a support point. An investor may therefore set a stop-loss limit of $30. Later, the stock experiences a brief downward turn — say, to $35 — but goes back up again. The investor then revises the stop-loss limit to $35, as it indicates a new support level.
Others use long-term moving averages to set their stop-loss limits. If the current price of a share is higher than its 100-day moving average, they’ll set a point just below the moving average where they want to sell it. This is practical because it prevents sudden, temporary stock movements from influencing your stop-loss limits. It’s based on long-term history and potential, not freak accidents.
Placing a Stop-Loss Order
You should place a stop-loss order on every position you own if you can. If you own expensive stock, you might want to be fairly strict and set a limit that will prevent you from losing too much — say 10% or even lower. If you own several inexpensive growth stocks, you can probably withstand a larger percentage price drop. But make sure that you have a stop-loss limit for every commodity.
When you place a stop-loss order, don’t assume that it will automatically generate. Some brokerages establish deadlines after which the orders are canceled, regardless of whether they’ve gone through or not. Look for confirmation that the order has gone through.
Day traders don’t generally use stop-loss orders, except as a component of profit/loss ratio trading (but more on that in a bit).
Set a Target Price
Conversely, at some point, your shares may experience consistent gains in price with no obvious sign of a downturn on the horizon. You may decide to order them to be sold once they hit that price and pocket the profits.
The process for cashing out at a predetermined price is called a stop-limit order, and it’s similar to making a stop-loss order. Instead of setting a price below your initial level of investment, you aim for a target price above the chosen price to maximize profits.
The risk of setting a target price, at least for long-term investors, is that if a stock is on an upward trajectory, it could keep on going up. That means you won’t get as much for selling the stock at the price point you chose as you could if you’d stayed in a little longer.
But the upside is that you’ll lock in profits. The nature of the current stock market is that it doesn’t take a long time for certain commodities to earn 20% or 30% — sometimes, it’s just a matter of weeks. If you cash in, it’s easy to get back into the position if you change your mind or simply reinvest in another promising stock.
Stop-limit orders can also be adjusted in the same way that stop-loss orders are. If the price keeps going up but hasn’t quite hit your limit, you can revise it to a higher limit if you’re convinced there’s still room to grow. Another strategy is to only sell part of your holdings in a certain stock when it hits the limit and hold onto the rest in anticipation of it going higher.
Set a Time Limit
Some traders, especially those taking short positions, simply hang onto their shares for a certain predefined time. Then, regardless of whether they’ve earned or lost value in their holdings, they sell it on that date.
This might sound a little counter-intuitive, but there are some good reasons to employ this strategy. Keeping too much money in stagnant stocks drags down your portfolio and can cause you to miss out on other promising options. If you’ve held a position for a year but only recognized modest, single-digit growth, it makes sense to unload it and put the profits somewhere else.
Day traders are all about setting time limits. Their deadline for unloading stocks is the end of each trading session. Shares they haven’t sold to capture profits at the end of the day are then put back on the market.
If you have a stock that’s only grown incrementally since you’ve owned it, at the very least set a deadline to re-examine whether it’s worth holding onto. It may still be worth selling just to keep your portfolio liquid and free up capital for new opportunities.
Set a Trailing Stop Limit
Trailing stops are different from stop-loss and stop-limit orders in that they don’t execute when shares hit an exact price point that you specify. Rather, the limit is adjusted according to how far above or below the price is from its current market value.
For example, say that you’ve bought into stock at $20. The price goes up to $23 when you decide to issue a trailing stop-limit order of $2. At that moment, your stop limit is $21. The price goes up again to $25 — and your trailing stop limit is $23.
But then the stock declines to $24.75. Your stop limit, though, remains at $23. If the stock ever declines further and hits $23, the sell order will be executed. If it doesn’t, the trailing stop limit will continue to rise as the stock continues to gain.
The trailing stop limit is exceptionally helpful because it automatically resets as the stock continues to gain in value. You’ll be able to ride the wave of an upturn and cash out at a profit, no matter what. Of course, the limits you set should make sense, and you should use them in combination with stop-loss limits to maximize their potential.
Other Trading Exit Strategies
Two stock exit strategies are particularly used by day traders. Rather than being driven by the fluctuations of a given stock, they’re based on the entire value of the trader’s portfolio. Let’s take a look at each of them.
Profit/Loss Ratio (P/L)
Day traders often set their trading systems up according to an acceptable ratio of gains to losses. For example, their goal might be to trade to maintain a profit/loss ratio of 3 to 1. That means the average profits from all their winning trades is three times the average losses of their losing ones.
For example, say you buy shares in a stock at $20. You believe the stock will eventually hit $21, at which point you’ll sell your shares for a profit of $1 each. You use a P/L ratio of 2:1, setting a stop limit at $21 and setting a stop-loss of 50 cents. You’re willing to risk losing those 50 cents but hope to get that dollar.
Day traders balance their holdings during the day in hopes of maintaining a reasonable, profitable session, making strong gains while accepting limited losses.
The 1% Rule
As more of a guideline than a hard and fast strategy, the 1% rule simply says that you should never put more than 1% of your liquid net worth at risk of loss. For example, if your total savings and investment account is worth $200,000, you should never have more than $2,000 exposed to potential loss at any time.
Day traders often feel that the 1% rule is too restrictive. They may feel more comfortable putting 2% or even 5% of their total investment capital at risk. But whatever limit you set, it’s good to have one.
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