Why You Should Never Enter Trades Without an Exit Plan

Over the years I’ve met many investment professionals. Only one has made selling his primary focus.

I met Don Cassidy after he’d retired. He worked as a research analyst at Lipper, a firm that specialized in mutual funds. I had retired from the Air Force at about the same time.

We bonded over the fact that neither of us were very good at being retired. Instead of learning to take it easy, we both needed new projects.

While I got busy creating trading algorithms, Don wrote several books on investing — including It’s When You Sell That Counts.

There’s quite a bit of information in that book, but one of the most important points is that you should plan your exit before you enter the trade.

It seems obvious, but this is something few traders think about — or are otherwise misguided by outdated practices.

So, today, I want to debunk a popular selling strategy that’s likely to get traders into trouble. And I’ll share a more logical sell strategy which applies to the ranked ETF strategy we’re hard at work on.

This Popular Exit Plan Is Not Foolproof

The idea of finding a strong exit strategy applies to everyone. Whether you take short-term trades or long-term positions, you should know what price will cause you to close the trade.

Maybe you’ll close when the price hits a profit target, or a stop loss. Maybe market action will dictate the exit. Sometimes, an indicator can dictate the timing of the sell.

There are countless possible exit strategies. The best one to use largely depends on your entry strategy. Yet, many traders who jump into the options market don’t set clear rules for selling their positions.

I’ve spent a lot of time thinking about this over the years, and have tested a number of different sell strategies. But since I’ve been writing about a relative strength (RS) strategy lately, I’ll use that as an example.

To use this strategy, I created a list of ETFs. I calculate RS for each of these ETFs and sort the values from highest to lowest. (You’ll recall that I used this strategy to manage over $200 million some years ago, and we’re now testing this strategy as an entry-priced trading advisory, set to launch early next year.)

ETFs that are relatively stronger are near the top of the list. I recommend buying the top-ranked funds. That part is easy.

The hard part is defining the sell rules…

A popular exit strategy is to use a stop loss and a profit target. But individual investors tend to use arbitrary rules for this approach.

One popular guideline, from the book How to Make Money in Stocks by William O’Neil, is to use a stop loss of 8% and a profit target of 24% — three times more than the stop loss.

Two issues jump out. First, you can’t always limit a loss to 8%. There will eventually be larger losses because markets can move quickly, and your stop-loss order will get filled however market makers can manage it. That’s if they aren’t hunting your stop loss in the first place.

Second, you’ll never have a big enough winner to offset the unexpected losses since you capped the upside at 24%.

So instead of an arbitrary approach, I use a logical process.

My Cast-off Strategy  

In my ranked ETF strategy, we will hold up to 10 ETF positions. One sell rule could be to close a trade when the ETF is ranked 11 or lower.

Though, that’s not a good rule. The strongest stocks and ETFs often pull back in uptrends. Traders following RS strategies — and there are many of us on Wall Street — will see these pullbacks as buying opportunities. That means pullbacks are often short-lived and the uptrend can resume after a few days.

If the ETF fell to a rank of 11 on the pullback, the rally would push the rank to 10 and we’d be moving in and out of the same position every few days. This is a problem because it increases trading costs and can generate tax bills.

To avoid that, I adopt a “cast-off” strategy. I sell when it’s clear that the uptrend is most likely over.

To do this, I hold as long as the ETF’s RS is ranked in the top 30% before I cast off the holding. This allows for pullbacks and allows us to hold for the long-term gains an RS strategy can deliver.

The right selling rule is important because this is a long-term strategy. Cast-off rules balance risk and reward, and in the long run should maximize wealth — which is the ultimate goal of trading.

Regards,

Michael Carr, CMT, CFTe
Editor, One Trade

P.S. Knowing when to exit a trade is just as important as knowing when to enter one. And nobody I know has better instinct for trade entries than my colleague Paul … 

Right now, Paul is opening up access to one of his most successful trading advisories. In it, he trades lesser-known companies in innovative fields. That means a fair amount of volatility — but also much higher profits.

But this is far from simple speculation. Paul draws on historical analysis to determine the exact moment these stocks are set to explode in value. 

And the data doesn’t lie: Paul’s shown his readers gains of 638%, 450%, and 393% using this strategy.

Paul’s constantly on the lookout for stocks with this same potential. To make sure you don’t miss his next discovery, go here to learn more about his strategy.

Chart of the Day:
Energy’s Catching a Bid

(Click here to view larger image.)

There’s a lot to like about the chart of the SPDR Select Sector Energy ETF (XLE) right now.

You might recall that this was Chad Shoop’s sector focus in the Monthly Market Outlook we released last Wednesday. Energy’s taken a couple lumps since then, but now, the sector looks hugely bullish as we carry on through December.

Let us count the ways…

For one, the 20-day MA is sitting right on top of the 50-day MA. This will be the first time those averages have met since the former crossed above the latter in late September. Especially as XLE is set to open 1.6% higher this morning, above the 20-day MA, I’m expecting that line to bounce and continue its uptrend.

We also have a positive bullish divergence on the Relative Strength Index (RSI) indicator. As the price action in XLE has made a lower low, the RSI set a higher high. That’s a common signal of future bullish price movement.

With today’s price action, we’ll also likely see the MACD perform a bullish cross. The last time we saw such a cross on the daily timeframe, XLE rose roughly 22% to its peak.

So if you were following Chad’s energy trade and got shaken out by the last week’s chop, now looks like a good time to jump back in.

Regards,

Mike Merson
Managing Editor, True Options Masters