Trade Exits and Opportunity Costs


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There are many approaches to initiating trades and selecting stocks for investment purposes, but many of the “experts" who provide advice on getting into a day trading or investment position fall short when it comes to insights into when and at what price to get out. Let's assume for purposes of this discussion that you have a rational basis for making the investment, or initiating the trade, in the first place, and that you have a reasonably well-disciplined approach to cutting your losses if the price of the stock does the opposite of what you expect or hope. Often the situation that experienced traders, and especially long-term investors, have the most difficulty dealing with is the happy period when the price of the stock has risen well into the profit range. How do you know when and where to get out?

A brief description of the economic concept of “opportunity cost" can help us bring some logic and good judgement to the challenge of deciding when to exit trades. Opportunity cost is the value of the next best thing you can do with your resources. Your resources clearly include your money, but they can also include your time and your comfort. For example, let’s say you bought a ticket to a show or game that you really look forward to seeing, and when you arrive for the big event you discover that fans are offering to buy tickets from scalpers for ten times the price you paid.

Now, you might think that your cost of attending the event is simply the price you originally paid for the ticket. But, in economic terms, your cost is equal to the value of your second highest priority choice about what to do with both the time you have allocated to the event for which you hold a ticket, and the amount of money you could get by selling your ticket at the new, higher free-market price. Your “opportunity cost” for using your ticket to see the event rather than converting your ticket to cash is equal to the price you could get for your ticket rather than the price you paid for your ticket.

How does this apply to exiting a trade or an investment? It is actually quite simple. As your profit in a given stock or investment increases, at regular points in time based on the time horizon of your trade or investment, you should ask yourself if you would buy the asset you currently own at the current price as a new investment or trade. If the answer is “yes” then keep holding, but if the answer is “no” then it is time to convert to cash and take advantage of that second highest priority trade or investment that is waiting for your time, attention and capital. Whether you are day trading or investing for longer periods, it is often best to take the easy, early profit from a trade and then convert to cash so you can objectively evaluate the other opportunities available to you.

Of course, you should never let the temptation to take profits early interfere with your ability to maintain disciplined management of your trading system or investment plan. Patience is the key to profitably managing any system.

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