A good trade requires both a smart buy and a smart exit.
music selection: “All Fired Up” — Pat Benatar
Financial media has an obsession with finding good entry point. The equally important step, finding good exit points, is often ignored. I want to give some basic guidelines on how to exit your trades like a raptor.
The first exit strategy is the one that had made the very most money for patient traders. That is to not have an exit strategy! You buy a solid company with a defensible and sustainable competitive advantage with no intent of *ever* selling. Forty years later, compounding has made you a rich lizard. There is a time to apply this strategy. It goes well with profitable insurance underwriters and companies that are growing their shareholder return consistently (dividends, debt payment, share repurchases). Don’t be a slave to your strategy though. If the underwriting turns south or the company becomes technologically obsolete (Eastman Kodak), you have to recognize the thesis has changed and it is time to take profits and run.
The second strategy is a simple stop loss. You define your maximum pain point upon entering the trade. That is often times 1% of your portfolio. So, if your allocation is 4% to a particular stock, you exit the trade if it closes more than 25% below your entry point (.04 * .25 = .01). The intent here is to avoid catastrophic losses.
The next strategy is the trailing stop loss. This is a strategy that moves as a stock increases in price. If the stock moves up ten percent, your stop price moves up ten percent with it. This closes out your downside risk and has the benefit of locking in profits after a meteoric rise. You don’t know when the pullback is coming, only that it must eventually happen. The trailing stop loss gives you mathematical discipline to keep you from holding a big winner until it turns into a big loser on the hope “it can gain back its losses”. Never enter your trailing stop losses in the market. Especially on low liquidity stocks. The market maker will pick you off and you will live money on the table. Track your trailing stops offline and exit the following day when the stock closes below your moving stop price.
A favorite strategy of mine is profit taking. At the time of purchase, you set a target. Not a price target but a performance target. You might think XYZ company would be fully valued based on peer pricing and historical pricing at 21 times Free Cash Flow. When XYZ hits your target, you sell covered calls that are slightly in the money at the nearest expiry. You will likely earn over 12% annualized to get your exit price.
Don’t be in too big of a hurry to redeploy cash when you have been stopped out of something. The raptor way is to keep significant cash on hand to seize opportunities or to secure put writing on our favorite shareholder return stocks. We always demand at least 12% annualized return for our trouble.
Devour your prey raptors!