"Affairs are easier of entrance than of exit: and it is but common prudence to see our way out before we venture in."
-- Aesop, Ancient Greek Philosopher and Story Teller.
An exit strategy is always a precondition for any trade I enter.
All other strategies will have disaster at their core. All other strategies are simply an emotional reaction to external events. All other strategies accentuate reward while ignoring the damage incurred by accepting too much risk. These are strategies I refuse to implement in my trading strategy. My trading and investing success is based on controlling risk, preserving capital, and increasing gains where possible. Once I survived those freshman errors of trading on emotions that every beginner trader makes, I began to survive as a investor.
All beginner traders are emotional when they begin their trading career, regardless of how long or short their trading career lasts. It's not their fault. It happens to everyone. It's caused by the excitement of "easy money". Most beginner traders worked hard to put together a sum of money to afford them the ability to establish their first trade. What they often discover is that by simply clicking a mouse a few times they can open an brokerage account, buy a stock and, if they're correct in their decisions, sell their stock realizing both a profit as well as the excitement of receiving the easiest money they have ever made in their life.
This type of situation is extremely addictive to the beginner traders. It provides an emotional high and an enormous boost to self confidence and enhances their self image. It's an enormous and transformative ego boost and a confirmation that they are smarter than the average trader. They conclude that trading is easy, obvious, and they wonder why they hadn't done this long before now. But like most things that are addictive, the emotional high only lasts so long before an ugly reality begins to set in.
As a stock moves up in value, greed begins to creep into the psyche of the beginner trader. He begins to calculate how many years it will take before he's a millionaire. He begins to calculate how he can double down on his investments to speed up this accumulation of wealth. Greed becomes the single most important factor in his trading decisions. Risk is ignored and disaster enters stage left.
Sadly many beginner traders will eventually lose all their capital and exit the market forever. They will end up blaming the markets for what is actually their own inability to control risk. They've let their emotions control their trading decisions because they didn't have a plan to control the risk associated with their trades. As much as their greed encouraged increased trading when the trades were successful, fear now discourages their trading when their trading becomes unsuccessful.
Trades that are going poorly bring to the surface of the trader's psyche his inherent fear of bankruptcy and a life of poverty. As much as greed makes the beginner trader dream of becoming a millionaire, fear makes the beginner trader anxious over losing everything and falling into that abyss of poverty. It's the natural psychological conclusion for a trader whose trades are based on emotions and his emotions are out of control. An experienced trader would instead simply accept the loss, sell the position, and move on to the next trade. A beginner trader who had been bolstered by earlier successes interprets this situation as the market being wrong, he is still right, and the market will understand and correct itself over time. His fear traps him into holding onto a losing trades until his account is decimated. In the end these stocks often lay dormant in his account for years because he's unwilling to declare defeat and sell. It's a sad situation but it occurs everyday in the markets. The only value these trades may ever have will be as a tax offset for future successful trades that will probably never occur.
There is only one way that I know of to stop this disastrous style of trading based on emotions and that's having a trading plan in place before the initial trade is executed. A good trading plan will have specific conditions for entering a trade as well as the resultant conditions for exiting a trade. A good trading plan will have a back up plan for when the trade act differently than originally expected. A good trading plan will be simple, and it should be written down as a set of simple rules and conditions. And finally it's one that can be executed successfully.
It is this exit strategy of how and when to exit a trade that makes a trader successful. It's this exit strategy that keeps a trader trading for decades instead of weeks. It's this exit strategy that eventually turns the beginner trader into the seasoned successful investor.
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