Once you`ve found the best entry point for your stock trades, you need to keep your position out of trouble while you hold it and wait for potential profits. How does a position get into to trouble? In an environment as volatile as the market, there are many ways, but the one that often triggers a position to move against you is market news. The only way to guard against sudden turns in the market is by setting stops. Stops must be set on every trade. This topic is so important that I`ve devoted several articles to it that you might want to read for more detailed information.
But generally, when you make your trading plan, you must decide where to stop out if the trade goes against you. Do you want to stop out of the stock at a small loss and abandon the trade, or average down by increasing your holdings at a lower price, keeping a loser stop in place even farther down? The best idea is to stop out at a small loss. There aren`t many times when averaging down works. You should limit the averaging down option to extremely low-risk plays with high chances of success. These should be stock trades in which you`ve determined that a price decrease to the level where you`d average down is not a sign of an impending drop but just a temporary move in the stocks range.
The best way to figure this out is by looking at support levels on charts. Averaging down does not mean you don`t have to set stops. It just means you`ll set them lower and give the stock more room to move around before you trade out of it. With appropriate stops in place, you will be practicing good money management. And good money management is the key to protecting your capital, keeping it intact for the stock trades that will create profits.
Once you`ve started to make profits on your stock trades, you need to decide when to exit the position. Your trading plan should tell you when it`s time to exit. Knowing when to exit is vital, because traders who hold on to their positions too long often find that their paper profits disappear. They often end up making no money, or even incurring a loss, on what should have been good stock trades.
To keep this from happening to you, it`s useful to think about how the risk-to-reward ratio changes as a stock you`re holding rises in price. The reward level decreases as the profits in your portfolio increase. There is less reward there because you`ve already collected most of it. The risk rises at the same time. As the price rises to a point where traders start to question how much more it can move, they start to take profits. If the risk is increasing while the reward is decreasing, at some point your risk-to-reward ratio will become unfavorable. You will already know that point is for each trade, since you will have calculated it before you made the trade, according to your trading plan.
Your plan may specify a particular number you`ve chosen as the exit point, or it may tell you to exit when the volume dries up, or to use trailing stops and hold the stock until a trailing stop is triggered. All of these are firm plans that tell you when to leave the position. Your exit plan also may have alternative exit points, and may tell you that if any of several possible things happen, you should exit. These are all good exit plans.
Last, in your stock trades, as long as you have an exit plan in place that is triggered by an unfavourable risk-to-reward ratio, you will never lose your profits. Instead, like all other successful traders you will take your profits at the point that is best for your personal trading style, in accordance with your carefully thought out trading plan.