I have long considered an exit strategy to be one of the paramount necessities in successful trading. When I write that, I don't mean an exit strategy that comes as some afterthought once a trade has already been entered. I mean one that is considered, developed, and in place at the time the trade is entered. All too many retail traders seem to fail to consider specifically and precisely what circumstance or circumstances will trigger them to pull the plug on a trade and as a result, tend to let their losses run. Of course, the idea is to let profits run while cutting losses.
I am well aware of the arguments that some advance for refraining from placing a stop, but if one is not able to watch the market quite closely (i.e. they have some other job that distracts them from their trades) then placing a stop loss order seems to me to be a prudent action. Better to take the quick loss with a stop than take the larger loss by convincing oneself that "it'll come back." In fact, the "it'll come back crowd," in my experience are among those most likely to be out of the trading business most quickly.
Even those who are able to watch their positions quickly may consider placing a stop loss or trailing stop loss order to avoid following the advice of that little internal voice that may be saying: "Oh, I'll let it go another dime." All too often it seems that dime becomes a quarter or a dollar or more.
For me the difficult issue is not whether or not to place a stop, but where it should be placed. The idea is to allow the position to have some breathing room but at the same time to set up the trade so that losses are promptly cut when they arise. A stop loss order can do that but since where to set it is a very subjective judgment it takes time and practice to become relatively good at doing it. My advice is that it is worth the time and practice (as in paper trading) to become as good as one can at setting stops. That does not mean that a trader won't ever get whipsawed out, it just means that he won't suffer the whipsaw as often and he will succeed in cutting losses. When we are stopped out, it is not a bad idea to keep watching the stock for a while to see if it does reverse in which event a re-entry may be in order. Re-entering is something few retail traders do, but it can lead to some fine successes.
In my experience teaching and coaching traders, I have found that many have a tendency to be impatient. While I do not advocate impatience when seeking an entry, I might suggest that once a position has been entered a time stop might be appropriate. Over the years, I have spoken to some successful traders who close a trade if it has not become profitable in 3 days, or in a week. They set their own time tolerance and if they don't get a move in the direction they seek within their pre-set time frame, they just close the trade. Naturally that can result in missing some moves that might occur shortly after their exit, but that is something they understand and accept. That approach might also add to the number of commissions they might pay in a year but at least it helps deal with their internal difficulties with patience.
Bottom line as I see it is that cutting losses can be critically important to good trading. Setting stops is one way to accomplish it. If you have others that work well, that's fine, but traders should have some exit strategy and a way to implement that strategy.
by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved
P.S. Save $50 PER MONTH on my subscription trading newsletters!
SAVE on my Under $10 Stock Trader Service!
SAVE on my Option Trader Service!
SAVE on my Trend Trader Service!
Technorati tags: stock trading stock market investing trend trading swing trading option trading stock options stock option trading Bill Kraft
To comment on Bill's article click on the "comments" link below.