Trade risk management, part 2: Entries and exits

Picture 2 traders, Random Randolph and Purposeful Puja.

Randolph enjoys the stock market and all the opportunities it offers. He recently invested in some tech companies because he liked their products, some real estate investment trusts because he felt real estate was about to recover and some junior miners because his cousin thought there was a lot of upside.

Puja is just as interested in financial markets, but she has a much clearer focus. She likes companies that are growing their sales and earnings by a certain amount over the last 12 quarters, at a time when the stock's short-term moving average is breaking above its long-term moving average, on significantly increased volume.

This is just one example of a trading system. There are countless other systems investors can use, depending on their investment objectives and risk tolerance.

To manage entries and exits in a trading system, it's much easier to be like Puja than Randolph.

When you have a clear focus for your trading, you become better at seeing patterns of what works and doesn't work. You get a better sense of how much a stock might rise if it beats earnings expectations or how much it might fall if it misses. Perhaps most important of all, you become better at saying no, since you recognize which opportunities are in your wheelhouse and which ones are not.

Try picking a limited number of systems — even 1 or 2 — and learning from your experience. The definition of a system includes:

• Universe of stocks, such as the Russell 3000 or Toronto Stock Exchange.
• Inclusion and exclusion criteria, such as Puja's screen for high-growth stocks.
• Entry and exit rules, like setting targets, stops and layers.

Based on how she has defined the trade, Puja can now set price targets, both upside and downside. She believes that volatility will likely be high leading up to the regulatory decision in 6 months, with possible downside below -10%. But if the drug were to be approved, Puja sees possible upside of 100% over the following 12 months. She realizes that her estimate, although informed by other growth stocks she's seen in recent years, is still a rough estimate, since stock prices can move in ways that are hard to predict on particularly good or bad news.

Since Puja believes the stock could lose more than her downside target of -10% in the first 6 months, she decides to limit her risk by entering the trade in 3 layers. If the drug were to be approved and the stock were to rise, she plans to sell in 3 layers — at gains of 20%, 40% and 60%. These targets make sense for Puja in this situation. For a different investor or investment, other targets could apply.

Puja has become more confident in estimating upside and downside targets because she has seen quite a few high-growth opportunities. While it's hard to say whether she's become better at identifying winning trades, she has become better at exiting losing trades.

In contrast, Randolph's eye is wide-ranging but unfocused. Since his trades are opportunistic or random in nature, he struggles to find any patterns in his trades. This makes it hard for him to manage entries and exits based on upside and downside targets.

Managing entries and exits is the key to successful trading, which should feel more like a process than an experience. To develop this process mindset, set your trading plan ahead of time as much as possible, leaving only limited discretion. This takes the emotion out of trading and keeps you focused on probability.

With this in mind, here are some key takeaways:

• Define the system. Pick a limited number of trading systems — even 1 or 2 — and get familiar with them. This will help you learn and improve your trading over time.
• Define the trade. Set a clear purpose for the trade and stick to it. Plan ahead for when and why you would re-evaluate the trade.
• Set targets, stops and layers. Establish upside and downside targets with hard or soft stops, using layers as appropriate to manage risk and reward.