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Feb 06

When To Exit A Trade

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Something you will hear me talk about often as a way of communicating my process is defining the different areas of a successful trading strategy. For example it’s my belief that entry is a lot less important than people make it out to be. That’s not to say it’s unimportant, but rather that many people put too much emphasis on finding entries.

Entries don’t determine whether you take a profit or loss on a trade. Exits do. By definition only once you’ve exited can you determine a trade to be a winning or losing one, and position size determines by how much. Your entry setup simply determines how many times you have a position, the frequency of your trades.¬†Of all these I actually believe position sizing to be the most important. But for now let’s concentrate on exits.

When should we exit a position? Ask that question at a trading conference and you’ll get a hundred different answers, many of which may concentrate on the ‘it depends’ angle because we all have different timeframes, objectives, and strategies. I think they’re looking at it the wrong way and it’s possible to define it objectively for all.

Let’s look at some exit methods that many subscribe to.

The fixed percentage loss – No matter what, you take the loss when you’re down by 8%. OK, I understand the need to cut losers, but why a one-size-fits-all 8%? Why not 6%? Or 7%? What if it’s 7.99%? Should I round up? Does that extra 0.01% really change the fundamentals or technical condition of that company? Of course not.

It’s an arbitrary number. It’s good that the need for risk management is recognized but plucking a number from the air is going to make people second-guess when it comes to the crunch. And why have a stop that can be triggered on a daily basis when your methodology for entries is partially based on weekly charts?

What about using profit targets, or price targets as exits? Nope. Don’t even go there, unless you want a job on Wall Street. Think about what placing a price target on a trade is saying. It’s saying:

“I want to limit my gains.”

“This is the most I’m prepared to make on this trade.” (What??!!)

“At this arbitrary point in the future I am predicting my analysis will suddenly be wrong.”

Seriously, if you’re that good at knowing that’s where it all comes undone then maybe you shouldn’t take the trade trying to get there, maybe you should just put in an order to do the opposite if it gets to your target and let that be your trade. Because otherwise it seems to me you’re saying when you enter the trade it could be right or wrong, but when you exit it can only be right, otherwise why exit? Ever notice that? Wall Street research analysts never give you their stop loss, but they always tell you their profit target. That’s messed up. Don’t do that.

So how can we always know our exit at the time we first enter a trade if it’s not necessarily a fixed price, a dollar amount, a percentage, or a point in time? All of those can be factors but they do not define it. It needs to be unequivocal. Here it is:-

YOUR EXIT SHOULD BE THE POINT AT WHICH YOUR ENTRY RATIONALE IS INVALIDATED.

Nothing else.

So getting out because you gave back some profit but the reasons you entered are still good, or your P&L hitting a nice round number, no, that’s not gonna cut it, that’s just a way for you to feel better about yourself and avoid cognitive dissonance. You need to get over that, that’s a “my head isn’t straight” exit. Get it straight. Otherwise you’re creating a trading rule based on how it’s going to make you feel. Good luck backtesting that.

If the reasons you bought something still exist but you feel a need to exit based on arbitrary factors then you need to examine those feelings and what basis they really have in your trading, because they’re saying something about you, your mindset and biases rather than your position.

For some this may even bring about the realization they don’t have a robust entry rationale. If you’re trading without one you can’t possibly have a hope of knowing when to get out. If you can define your conditions for an entry you should easily be able to define when those conditions are absent. Don’t allow yourself to get to that place where a ‘trade’ becomes an ‘investment’ because you can’t recognize when you’re wrong.

When your reasons for getting in are invalidated, get out.

 

5 comments

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  1. Laurie Itkin

    I disagree with one of the points in your article. Yes, I do want to limit my gains. That’s why most of my trades are covered calls. In exchange for limiting my upside, I get monthly income and downside protection. I am more than happy to enter into a covered call knowing that I will be forced to sell my stock at a certain price.

    1. Jon Boorman

      Hi Laurie, yes that’s fair comment, with options there are very specific dynamics of price and time in equating your risk-reward, arguably your exit is still determined by the absence, or fulfillment, of the original conditions that prompted the trade, so it still fits into the spirit of what I was trying to convey. I was thinking more of the price targets that are chosen arbitrarily and often lazily by analysts simply because they have to, it reinforces people’s need to be told what to do, setting a target so they know when to ring the register.

  2. rfox77

    That makes a lot of sense Jon. I really like a lot of the things you say here and your thinking process. Makes me realize how long I have to go until I will be able to get to your level. I’ve made a lot of mistakes over the past 6 months trying to trade, but I’m ready to start over with a REAL plan and stay disciplined.

  3. Pete

    Excellent commentary on profit taking Mr. Boorman. Just discovered your site after listening to your fantastic interview by Michael Covel on his site.

    Question: My method has me taking profits on approx. half a position moving in my favor, using a tight trailing stop, with signal usually prior day’s low taken out and/or breech of 10-day moving average. Then letting the remainder run with looser stop. Do you ever take partial profits using a similar strategy? Thank you.

    1. Jon Boorman

      I don’t. I think taking profit in that way would suggest it’s fulfilling some other emotional need, rather than a price-based action. To me, a position is either valid or it isn’t. Only when it’s no longer valid will I exit the position in its entirety. I add to winners, I don’t take away from them. If it works for you that’s fine, but make sure you understand why you like to do that, is it statistically proven it’s more profitable that way, or does it just make you feel better? might be interesting to find out. Thanks for reading the blog and listening to the podcast.

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