Saturday, February 02, 2008

Targets and Exits

I sometimes get emails from subscribers who want to know whether I set targets on positions I enter and, if so, how I establish the target. If the question means do I set a target that once hit will result in my exiting the position, the answer is no. For example, suppose I am in a bullish position in XYZ that I entered at $20 and a target was set at $25. If the target is hit, what is to say that the price will not continue to go up? If I exited at the target and the price went to $40, didn't I just cut my profits? The objective for successful traders is to cut losses, not profits, and to let profits run. How can I let a profit run if I sell the stock when it hits a target?

Targets do have a place in my approach. I use them to calculate an initial potential reward to risk ratio. Using the same XYZ example, above, I know where my initial exit will be when I enter a position. I want it to be close to my entry price and I want it to be clear. The clarity can come from a break through a support level, for example. Resistance can supply the target. Suppose I buy XYZ at $20 and my pre-determined exit if the play goes south on me is $19. Resistance in this example is at $25 so, in a sense, that is a target. Now I can see that my potential reward to risk ratio at entry is 5:1. Pretty decent reward to risk, but does that mean I should exit if the stock hits $25? Not for me. I don't want to remove the possibility that the price can continue up so instead of exiting at the target, I would move my stop up behind the price and as it got closer to the "target" (resistance in the example) I would just move the stop tighter. If I get stopped out on a move back from resistance, that's fine. I would have my profit and would not have cut my profit. If the stock moves up through the target, I would still be in the position and could continue to move the stop up behind the move.

In my opinion, exits are much more important than targets. We only realize our profit or loss when we exit the position. If we exit properly, we do what we should -- cut our losses and let our profits run. Unfortunately, many retail traders are unsuccessful because they do just the opposite--cut their profits and let their losses run.

I want to thank the many subscribers who have bought my book, "Trade Your Way to Wealth." Last Sunday after only a week or so on the market, it hit #3 on the best seller list at Amazon for stock and option trading books. I hope those of you who have received your copies are enjoying the book and finding the information helpful. I tried to distill a lot of my own learning and experience into something readers would find valuable in their own trading without the necessity of re-inventing the wheel. Thanks.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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Anonymous said...

Very well put Bill, straight to the point & 100% right.

Anonymous said...

Your aproach is perefect and I use it all the times, But I found that more than often when stock reaches the target and you tighten the stop loss you exit the position 90% of the times due to the high volatility at taget levels, even when stock moves above the target.
I found better to exit at the target and be prepared to re-enter your position at higher price - works nicely with deep discount broker- otherwise slipage increases your losses in both winning & losing trades.

RR said...

That is the correct way to do trading, Bill. We should do the "cut loss" instead of "profit loss".

But at trading we are faced with the fact that if we cut losses too early, you just realize the losses. There is still possibility that the price will return, isn't right? Sometimes it is not easy to realize losses.

The question is: when is the right time that we cut losses?

Unknown said...

Good article & good timing. We discussed this today in our investment club meeting. I'd appreciate it if you would print a companion article verifying or debunking the theory that if we set stops, we're sure to lose the stock because the specialist will temporarily lower the price & buy it away from us. One of our leaders refuses to set stops & we've lost lots of money because of it. I have a mentor who like you, says we MUST set stops to minimize losses.

Bill Kraft, said...

Many thanks, Nigel, I appreciate your comments.
Bill Kraft

Bill Kraft, said...

Dear Anonymous,
I applaud your plan and congratulate you on some very smart trading. As they say: "You'll never go broke making a profit."
Bill Kraft

Bill Kraft, said...

Hi Rudy. Thanks for writing. When you say that there is a concern about cutting losses too early, I think of the old adage that can become the chorus for losing: "It's going to come back." Think about examples like Enron or Worldcom and how many lost life savings with the "it'll come back" refrain. If one gets out of a position and it then does turn back up, all we have to do is re-enter. There are many strategies to make good exits. A break down through a trend line, for example, or a moving average crossover are sometimes used. In my personal opinion, cutting losses is one of the most significant differences between the successful and unsuccessful trader. You may want to check out "Trade Your Way to Wealth" to see additional thoughts on how and when to cut losses.
Bill Kraft

Bill Kraft, said...

Hi Ed and Jeannette. Thanks for writing. While many folks seem to believe that a floor trader or specialist may drop a stock price to hit stops, every one I have spoken to vigorously denies the practice. I seriously doubt it would happen on heavily traded stocks. Imagine a floor trader trying to manipulate QQQQ, for example, to hit some stops. With that kind of volume it would be very difficult. Of course, floor traders are not stupid and know very well where levels of support and resistance are and, coincidentally know where many stops may be placed. I believe it is critically important to have some solid, disciplined exit strategy to which every trader is faithful. It could be stops, trailing stops, alerts, reaction to trend line breaks, etc. In light of your reaction to the leader's view on stops, you may want to see my views on investment groups and trading clubs in my book, "Trade Your Way to Wealth." Thanks for writing and good trading.
Bill Kraft

Unknown said...

Bill: Thank you so much for your reply to my comment about stops. I ordered your book immediately after writing my comment. We appreciate your educational material and use it in our investment club work.

Bill Kraft, said...

Hi Ed and Jeannette. Thank you for ordering my book. I hope it adds to your trading success.
Bill Kraft