How to Develop an Exit Strategy Before you Enter a Trade

How to develop an exit strategy before you enter a trade on the Dow, Nasdaq, S&P or any other stock exchange is one of the most important steps to making money in the stock market. Not only should investors know your investment style and match it to meet your end goals, but every trader must have an answer to the “what if” question. Failing to plan an exit strategy before you enter a trade can lead to clinging to a falling stock… and losing significant amounts of your wealth capital. There are so many great reasons to develop an exit strategy that we could fill a library. But, for our purposes, let’s simplify things a little and focus on just a few. Then, we’ll take a look at a few ways to develop an exit strategy.

Reasons to Develop an Exit Strategy

Developing an exit strategy is all about preserving capital, managing risk, and maximizing your returns. Most people plan their trades based on what they want to make – the profit side of the equation – with little consideration given to what they’ll do if the trade they make doesn’t go in their direction, but instead begins to lose money. Now what? Great question… but it’s one that needs to be answered before you place a trade.

Investors and traders alike need to develop an exit strategy:

• To Preserve Capital – If you ask most investors what their primary goal of investing in the stock market is they would likely say something like, “to make money.” And why not… who wants to lose money? Yet, if you ask those same investors how they plan on making money in the stock market, you’ll hear a variety of responses that tend to focus on buying low – selling high, or diversification, or dollar-cost averaging, among other catch-phrases. What you’ll rarely hear is, “by preserving my capital.” Unfortunately, what often happens is investors buy a stock and sooner or later find themselves “Chasing a Losing Stock.”
• To Minimize Risk – If you took a moment just now to read the article “Chasing a Losing Stock” you’ll see the undeniable simplicity of basic math… planning your exit strategy helps minimize risk. It keeps you from the temptation of adding money to a losing position or ignoring the falling price on higher volume indicators or being caught up in the emotion, no matter how sickening it may feel. On my weekly trades, I have a preset maximum loss (risk) that I’m willing to assume… and on my evening trades, the same thing applies.
• To Maximize Returns – As a stock price rises, there’s no need to sell out just because it reached a pre-determined target… although any win is better than a loss. Let’s say you want to make 10% trading Starbucks (SBUX). So, you make the purchase on November 19, 2010 at $31, set your sell order at $34.10 and walk away. In March 2011, you get the notice… it sold for a 10% profit. Congratulations. But what if you had some other criteria… and used stop losses to minimize your risk, used price and volume indicators to follow the trend, or, if you weren’t interested in doing any of that simply followed the daily or weekly posts here at Invest in the Markets? You may still be in SBUX today… at $43, a 38% increase.

How to Develop an Exit Strategy

Developing an exit strategy is very specific to you and your situation. It depends on your investment style, your goals, your experience, the amount of capital you can afford to risk, among other factors. Nevertheless, there are a few cautions you may want to take as you develop an exit strategy.

1. Ask the “What if” Question – What if your stock price fell 5.5% and it triggered the loss? Would you be comfortable with that amount of a loss? Would you sleep well? Would you be discouraged?
2. Develop Reasonable Expectations – Losses are a part of investing in the stock market… so if you expect to always gain and never lose, you need to adjust your expectations or stop investing in any stock exchange. However, if you know you may lose a little, you manage those losses, and know not every stock will take off and double over night, you’re on your way to developing a realistic exit strategy.
3. Assess your Time – How much time do you want to, or are able to, spend tending to your stock portfolio? Using a method like the Weekend Investor Strategy that requires approximately 15-30 minutes every weekend, you can manage your risk. However, if you have 5 minutes an evening, you can use the Evening Investor Strategy and be more responsive to the moves of a stock or market.
4. Ensure it’s Adjustable – While the principles of capital preservation, minimizing risk, and maximizing returns never changes, the stop loss orders will… so make sure your strategy is adjustable. Nothing rises forever so adjust your stop losses to follow the stock price upward, to ensure you get the maximum return with a reasonable amount of risk without letting it fall apart. A great example from recent markets would be Netflix (NFLX) which was once a darling of the market sitting around $300 (July 2011) to approximately $64 today (November 2011), a 79% decrease. While this stock climbed, wise investors were adjusting their stop losses upward and when the stock plummeted, they weren’t doubling down or chasing a losing stock. They were out, due to a rather simple exit strategy.

Before you Trade, Develop an Exit Strategy

Failing to plan for the rise and fall of your stocks is really a plan to be a failure. That’s not meant to be harsh… but unfortunately, it is the reality of many investors. It was true for me too when I first started despite being trained and employed by a major bank. Here at Invest in the Markets, we want you to be successful… this site is for you. I do not gain personally from any trade you make or decision to invest in the markets… but I enjoy hearing stories from investors like Gary Stutzman who wrote:

I’m embarrassed every time I think of how much money I lost over the past several years using the “buy-and-hold” and “dollar-cost averaging” strategies. Then I came across Invest in the Markets and learned about the importance of protecting my capital. Now, I use your Weekly Newsletter as a resource to provide me with ideas – I love how practical it is. And, in only 30 minutes a week, I’ve become a successful investor for the first time!

Have you developed a simple plan to get out of a trade or do you spend all your time figuring out what and when to get into a trade? As Gary discovered, how to develop an exit strategy before you enter a trade on the Dow, Nasdaq, S&P or any other stock exchange or individual stock is one of the most important steps to making money in the stock market consistently.