How Important are your Exits when Trading?

One of the things that separates successful traders from the majority of market participants is that they have a detailed plan that guides them when to close trades. For them, this is essential. It is fair to say that when a lot of traders buy shares they have little idea of under what conditions they would consider selling. It would also be fair to say that a fair percentage of market participants routinely adopt a ‘buy and hold’ approach.

Whilst trading routinely involves decision making, there are no more important decisions you have to make than when to sell shares. Many traders often overlook this part of trading or underestimate how important that it is. Importantly, the outcome of every trade is dependent on the exit. If you enter in a timely manner and then exit poorly, the trade could very easily be a loss. If your entry happens to be poor but your exit is good, you might actually still salvage a profit, or at the worst, minimise a loss. The exits, and not the entries, determine the outcome of your trades. Any form of backtesting will illustrate this point. You can take an entry signal but combine it with different exit strategies. You will quickly discover that you can drastically affect the overall results with only minor adjustments to the exit strategy. It could be argued that you cannot even conclude that a particular entry signal is effective because the final results are so dependent on the exit strategy used. Bad exits can make a good entry look bad and good exits can make a bad entry look good. Selling shares is probably the most difficult decision you will face but it is the most important. The decision is especially difficult when you are faced with a loss and all you want to do is wait for the shares to return to your buying price. The situation is made worse when the shares continue to move away from you, making your loss even greater than you would have ever imagined.

There are a number of reasons why people will not sell shares when they are faced with a loss. Consider the emotions in a person who is contemplating cutting a loss. Cutting a loss means that you purchased some shares and they went down. Your initial decision to buy was wrong and selling the shares at a loss validates your mistake. Cutting your loss means accepting that you were wrong and unfortunately there are many people who cannot bring themselves to do this. Yet, it is essential. Of the more than six billion people on earth, not one of them knows what is going to happen in the markets tomorrow or any day in the future. No one else knows, so how can you expect yourself to know for sure? Those people who run their own business realise that they make some decisions that work out very well and others that in hindsight, were poor and perhaps result in losing money. However, another thing that is for certain is that they would all accept the latter as being par for the course in running a business. People who manage successful businesses would naturally accept that experiencing a loss is just a part of trading.