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Hello - and welcome to Episode 7 in our ongoing series on Successful Trading.
In this episode, we’ll be looking at when to exit a trade when the price starts moving favourably. This is one of the most important components of trading, because it’s when we EXIT that determines the level of profit (or loss) we make on the trade.
In previous episodes, we’ve talked about setting up a precise set of rules that will tell us how and when to enter a position. We went on from there to talk about risk management and explained the need to set a fixed Stop Loss. This is how we keep our losses small – and avoid hanging on those horrors that end up in the bottom drawer.
Managing the risk in this way also ensures that we buy the appropriate quantity.
So here we are. The stock in our example is IPL and we have entry at $3.71. We’ve set our Fixed Stop Loss at $3.35
(the red line) and we have the right number of shares.
So we have a position; and we know what we will do if it goes against us. If the price drops to $3.35 we will exit the trade. But what do we do if it moves favourably? We need a strategy that allows us to start locking in profit. We do this by using what we call a Trailing Stop Loss. As the price moves up, we lift our exit point. Initially, this will see us reduce our potential loss and then move on into profit.
In our example, the Trailing Stop, represented here by the black line, has started moving up, and is now above the Fixed Stop. It has become what we call the Active Stop. This means it is now the stop that will trigger the end of the trade.
At this point, the exit is still below the entry point, but has lifted. If we exit now, the loss will be reduced. As the price moves higher, the trailing stop follows it up.
At this stage in our trade, it is now above the entry point. The trade is now in profit. Further upward movement sees more profit
being locked in as the black line lifts. This stage in the trade brings us back to a key issue we’ve talked about previously. Our exit strategy takes into account that price doesn’t move in a straight line – it goes up AND it goes down. So we need to give our trades room to breathe.
So here we are – the price is up nicely. At around $5.30 we can see quite a tidy profit over 40% - and because the price has never been THIS high before, the urge to close the trade now and take the profit is almost overwhelming. But I CAN tell you that giving in to this urge can considerably reduce your overall trading performance. The reason for this is that getting out of trades early tends to reduce the average of your profits. We touched on this previously when we looked at The Disposition Effect.
Common sense tells us we want to lift the average of our wins, but our emotions want us to jump out too early. Without a proper trading plan, this internal conflict is almost impossible to manage. And so – we Rationalise.“I can always get back in again”, we tell ourselves. But if we HAVE exited, it’s because we feared a drop in price; so we tend NOT to re-enter the trade, but rather we sit back and watch. We become spectators.
Let’s look at it for a moment. The young child goes to bed at night with the light on. Why? Because of a fear of the dark - the fear of the boogey man. Now, being afraid of the unknown is a rational fear, because we're unable to act against something that’s unknown. But price dropping? We KNOW that happens! Fearing something we know is going to happen is an irrational fear. Because we know it's going to happen –
we can prepare for it.
At this point in our example, giving in to fear would mean missing the rest of what turns into a really good trade. And I can assure you – there is little pain greater than the pain of foregone profit! So we KNOW the price will drop – but we don’t know when. We want to give our winners every chance – so we need to allow them some breathing space. The question then becomes “how much”> There’s simply no, one, absolute answer to this question. We all need to work out for ourselves where our tolerance lies.
But when we have a proper plan, we can TEST the alternatives to work out exactly how much ‘breathing room’ to give our trades. This will then allow us to set up a Trailing Stop, such as the one we have in our example. Once this part of the exit strategy is in place, we will not only know WHEN to get out of a trade - ee will also know when NOT to get out.
In our example – getting out this stage would be too early. The trailing stop has not been breached – so the trade stays open. Exit is not finally triggered until the price falls to the active stop loss – the black line. Exit is then actioned at the open of the next day at $6.69 for a very nice 80% profit. In the process, we locked away a much better profit than the 40% if we’d jumped out too early.
Having higher average wins is a key component of the trading equation and leads us to a positive expectancy. Next time, we’ll look at the trading process and how we use some of the tools of trading.
If you’d like further information, you can visit our website at hometrader.com.au, and book in to one of our free 2-hour information seminars.
Successful Trading 
