A piece that was published on Yahoo Finance by Brian Shannon, CMT of Alphatrends.net
Entering a stock trade is easy, but knowing when to sell (or cover a short) is a source of frustration for all market participants at some point. The emotional battle that is waged from within can be paralyzing at times. Do I sell now and take a small loss—or do I buy more? Do I take profits at my objective or hold out for bigger gains? These are just a couple of the questions that traders ask themselves when faced with a decision to close out a trade.
Knowing when to exit can be especially agonizing when it’s one of your larger positions or in a stock you may have personal feelings about. The first thing that traders must recognize is that the market does not care what any of us thinks the stock should do, and at the end of the day, our opinion does not count. So, the first thing to do is to leave your ego at the door. Price is the final arbiter. Only the market decides if we are right or wrong.
So, when should a position be exited? Professionals trade according to a plan that is thought out in advance. That plan is based on market action for their chosen time frame. The only true way to measure if a stock is behaving as it should is with technical analysis. Technical analysis lets us objectively assess price action, which allows us to leave emotion out of the decision-making process. Knowing when to exit a trade is accomplished by letting the stock tell us when to get out. You might be thinking, “How the heck is the stock going to ‘tell me’ when to cover?” The answer to this question is more straightforward than you would imagine, and it relies on simple technical concepts.
Figuring out where to exit a trade is easier than you think
When you enter a trade, the first technical consideration to be made is where support and resistance levels reside. An initial protective stop must be set to make sure that if the stock does not act the way we expected it to, our accounts are not exposed to a catastrophic loss. The best way to determine where that protective stop should be placed is by looking at the recent support or resistance levels. For longs, stops should be placed just below the most recent support. I like to use a 10-day chart using 10-minute bars for finding that support for a swing trade. For longer-term trades you would look at levels on a daily or weekly chart. For shorts, stops should be place just above a recent resistance level.
The weekly chart of Nvidia (NVDA) shows the remarkable run the stock has experienced. Longer-term investors may want to lighten up on their positions, as it has just broken important support.
Once a trade is moving in the anticipated direction, the goal is to hang onto that position if it is moving higher (for longs) or lower (for shorts). One of the foundations of technical analysis is that “a trend, once established is more likely to continue than reverse.” This premise can be exploited to maximize our profitable positions. The definition of an uptrend is “higher highs and higher lows.” If that trend remains intact, we want to hold onto our position—this is where we “listen to the message of the stock”.
Simply put, as long as the stock continues to make higher highs and higher lows, we will move our stops up under the support levels that are formed by the successively higher lows, allowing us to hold on as long as that trend remains in force. For shorts, the process is the same, except the stops are trailing down just above the successively lower highs that act as resistance for the stock. Using an exit strategy that exploits the nature of trends takes the guesswork out of selling and allows us to meet the age-old goal to “cut our losses and let our profits run.”