A good exit from an investment position is more critical and difficult to achieve than a good entry. The difference is that while an investor is waiting for a good opportunity to invest or to make a trade, there is no market risk. If one opportunity to enter is missed, a good investor or trader knows another will come along. When a position is entered, though, exposure to market risk starts instantly.
Indeed, failing to exit an investment position at the appropriate moment can cost dearly. That cost can occur through slow attrition as the investor waits for the investment's price to turn around, or it can occur if the investor is too cautious and exits at the drop of the proverbial hat.
The problem with frequent and hasty exits is that many small losses will occur because of the sacrifice of potentially profitable positions. A good exit strategy must control losses, but it must also allow profitable investments to fully mature.
The exit strategy must dictate how and when to get out of a position that has gone wrong so that a significant loss is prevented. This goal is often referred to as a "money management stop." This stop is frequently executed using stop-loss orders (often, the terms "money management stops" and "stop-loss orders" are used interchangeably).
The second goal of a good exit strategy, as stated above, is to ride a profitable position to full maturity. If an investment is going favorably, it should be ridden for as long as possible and for as much profit as reasonably possible. Single investments need to be viewed rationally; if you've made 30%, 40% or 50% on your position, it may be time to peel some of the profits away. (The lesson is simple: don't get too greedy.)
Exit strategies can be implemented in various ways. In fact, a complete exit strategy would make coordinated use of a variety of exit types to achieve the goals of effective money management and profit taking.
In a nutshell, a standard exit strategy uses three kinds of exits, but in a simple, consistent manner.
A fixed money management exit is one that closes out a position if the market moves against it more than a specified amount. For example, if an investor buys an S&P 500 ETF but is not willing to risk more than $1,500, the money management stop is set to close the position if the market moves against it by more than that amount.
A profit-target exit is the same concept, but on the opposite side of the coin: it closes when a predetermined threshold is hit on the upswing. So as soon as the market moves a specified amount in favor of the position, the limit will be hit and an exit happens with a profit. For example, consider a $500 profit target set on a long position in the S&P 500. If the market moves in favor of the position by $500, the position is closed.
A time-based exit is one that will close in a certain number of days, regardless of whether the position has been profitable.
If the position has not moved sufficiently to generate a profit or trigger another stop within a certain number of days, weeks, or months, chances are the position is dead and the money invested needs to be deployed elsewhere.
There are a number of other exits that are not as typical. These include trailing exits, volatility exits, and signal exits. These exits require a level of sophistication an investor or an advisor might not have. They all rely on a sense of timing that comes from a sophisticated knowledge of market or stock fundamentals, technical analysis, and/or intuition. As one example, a trailing stop is a stop-loss that shifts with the price when the price moves in the direction of the trend. So if the price of Castles In The Air Inc. has been rising steadily with an occasional fallback in price, the trailing stop is set at the current price minus the largest drop in price seen so far.
When I used to manage a bond desk for a major international bank, I relied on economics (fundamentals), mathematics (my version of technical analysis), and intuition to set exits.
The bond market is influenced by the economy at least as much as the stock market, if not more so. Therefore, it is very important to understand the effects of economic news and economic policy on the bond market. This sort of fundamental knowledge is the background we used to determine our positions.
We often set a limited number of volatility stops for the positions that were going to be unwound on a particular day. So, for example, expectations of a bad unemployment report might cause us to hedge any sudden market movements that could arise during the first hours after announcement of the unemployment number.
Mathematics, in the form of "generalized technical analysis," helped in setting trailing stops, while intuition (and the views of the head trader) was used for determining signal exits. These signal exits were the most difficult to set, but if they were done well they were often the most profitable trades.
To summarize, the standard exit strategy incorporates elements of profit taking, risk control, and time exposure.
The profit-taking aspect is achieved by setting a profit-taking limit; the risk-control aspect is handled via money management orders; and time exposure is handled by setting a maximum number of days a position can be in place.
The limits of a standard exit strategy include the fact that it is unable to hold onto sustained market trends. It also lacks any means for exiting a languishing investment at the best possible price.
However, recognizing the big picture means that a really good exit strategy is a key to successful investing. And the standard exit strategy is a good place to start and can be modified as the investor or advisor gains experience.
Keep in mind the maxim of many good traders and investors: an experienced investor skilled in money management can make a profit even in bad times, while a novice unskilled in money management can lose everything.
Andrew Clark is the manager of Alternative Investment Research at Lipper.