What is an 'Exit Strategy'
An exit strategy is a contingency plan that is executed by an investor, trader, venture capitalist or business owner to liquidate a position in a financial asset or dispose of tangible business assets once certain predetermined criteria for either has been met or exceeded. An exit strategy may be executed for the purpose of exiting a non-performing investment or closing a business that is not generating profits. In this case, the purpose of the exit strategy is to limit losses. An exit strategy may also be executed when an investment or business venture has met its profit objective. Other reasons for executing an exit strategy may include a significant change in market conditions due to a catastrophic event; legal reasons, such as estate planning, liability lawsuits or a divorce; or for the simple reason that a business owner/investor is retiring and wants to cash out.
BREAKING DOWN 'Exit Strategy'Regardless of the type of investment, trade or business venture that is entered into, an effective exit strategy should be planned for every positive and negative contingency. This planning should be an integral part of determining the risk associated with the investment, trade or business venture.
Exit Strategy for a Business Venture
In the case of a startup business, good business people always plan for a comprehensive exit strategy in case business operations don’t meet predetermined milestones. If cash flow draws down to a point where business operations are no longer sustainable and an external capital infusion is no longer feasible to maintain operations, then a planned termination of operations and a liquidation of all assets are sometimes the best options to limit any further losses. Most venture capitalists usually insist that a carefully planned exit strategy is included in a business plan before committing any capital. Business people may also choose to exit if a very lucrative offer is tendered by another party for the business.
Exit Strategy for a Trade
When trading securities, whether it’s for long-term investments or intraday trades, it is imperative that exit strategies for both the profit and loss sides of a trade be planned and diligently executed. All exit trades should be placed immediately after a position is taken. For a trade that meets its profit target, it could immediately be liquidated or a trailing stop could be employed in an attempt to extract more profit. Under no circumstance should a winning trade be allowed to become a losing trade. For losing trades, an acceptable loss amount should be predetermined and a protective stop loss should be placed and strictly adhered to.
In the context of trading, exit strategies are extremely important in that they assist traders with overcoming emotion when trading. When a trade reaches its price target, many traders experience greed and hesitate to exit for the sake of gaining more profit. Ultimately, this leads to winning trades turning into losers. When losing trades reach their stop loss, fear creeps in and traders hesitate to exit losing trades, causing even greater losses.