How to develop an exit strategy
Every investment has a beginning, a middle, and an end. It’s easy to focus on the beginning and the middle – building your portfolio and watching it grow is an exciting challenge. But you invest for a goal – maybe to buy a home, maybe to pay for your children’s education, maybe to retire – and to achieve that goal, eventually, you’ll have to divest.
But when is the right time to stop? And how? Selling everything at the first sign of a downturn may mean you’ll miss out on long-term profits. Holding on to a falling stock in the hopes of a rebound carries the same risk. Having a written down exit strategy before you initiate a trade can help manage emotions when you are in the middle of a trade and wondering if it is time to exit.
Limit and Stop Orders (or ‘Using Conditional Orders’)
To help make sure you exit an investment at a price you’re comfortable with, you may want to set up a “limit order.” This is a standing order to automatically buy or sell equities at a specific price, so you don’t get caught off-guard by sudden price fluctuations.
There are different types of conditional orders to manage risk and profit taking – stop loss on the down side and sell limit on the up side.
Stop orders or “stops”, are always set below the current bid price on a sell and above the current asking price on a buy.
Further, on the down side, there are 2 options (a) stop market and (b) stop limit:
Stop Market: an order to buy or sell a security at the market when the price drops to a specified level.
Stop Limit: a regular stop order that becomes a limit order when the order is triggered. It can be used to buy or sell when you want to be more precise about what price is acceptable. For example, you own a stock valued at $50, and want to protect your profits. You might set up a stop order at $40 with a limit price at $30 so that if the stock’s price drops to $40, a limit order will be sent to the exchange at $30. As long as the stock continues to trade above $30, your order will be filled. But if the price drops below $30 without a fill, the order will remain open on the exchange at your limit price of $30. This is useful in very volatile markets especially when you have no time to actively monitor the markets.
Trailing Stop: a stop order (either a buy or a sell) that trails the market price, is adjusted as the market price changes, and is executed as a stop-market order. A trailing stop can specify a dollar amount or a percentage.
For example, you buy a stock at $50, and set up a $5 trailing stop – you’ll sell if its price drops to $45. If the stock’s price rises to $70, the trailing stop follows it – you’ll now sell if its price drops to $65.
Limit orders can be distinguished from stop orders in the following ways: While stop orders may help to limit losses by selling in downturns, limit orders may help to protect profits by selling in upturns. While stop orders are set below the current security price, limit orders are set above it (except in the case of short positions, in which this is reversed).
Stop orders and limit orders can have time limits applied to them as well. You can specify that these orders last for one day, or until a certain date.
This video can help you understand order types.
Planning your exit
Limit orders are a great tool for structuring your investment because they require you to think about what you’re hoping to realistically achieve, and what you would be happy to end up with.
There are steps you can take to make a goal, and help yourself achieve it:
1. Set a timeframe
If you’re investing for a long-term goal:
- Consider placing trailing stop orders on some securities and letting volatility take its course on other securities.
- Placing trailing stop order might help you manage risk, but it may also increase the number of trades you make, which brings additional trading fees.
- Establish savings goals at regular intervals, to ensure you’re on track.
But if you’re investing for a short-term goal:
- Consider setting up stop-loss prices – as a short-term investor, you may not have time for underperforming securities.
Consider setting quick-turnaround profit targets at opportune times.
2. Set a risk limit
Every investment has a chance to succeed or fail. Success is good, but failure can be catastrophic, so you might want to make protecting against unacceptable loss your primary concern.
Setting a risk limit will determine the length of your trade and the type of stop-loss you will use. If you seek a less-risky investment, limit orders set tightly around your security’s prices may be one way to help decrease your exposure to sudden changes in price.
However, it might be a good idea to make sure that your limit orders aren’t triggered by regular, everyday market volatility. There are several ways to do this, including using the beta indicator. A stock’s beta indicator can tell you how volatile that stock is compared to the market. A beta of 1 means it’s in step with the market, while a beta higher than that means it is more volatile. If a stock’s beta is between 0 and 2, perhaps a stop-loss price between 10 and 20% lower than the purchase price might be a safe strategy. If its beta is higher than 2, everyday price changes might set this off, so you may want to set your stop-loss price lower.
3. Set a profit limit
A “profit limit” might sound like a strange idea – after all, why put limits on profits? It may be a smart strategy to choose a price at which you will have made enough profit and could happily sell (if not all of your position, then perhaps just some of it). By setting an objective price at which you exit, you might just take the emotion out of a difficult decision.
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