Saturday, September 12, 2009

Part III - The Basics: Some Ways to Let Profits Run

This article is the last in the current series dealing with the basics of cutting losses and letting profits run. Last week I focused on various ways to cut losses. Each is relatively simple but all require that the trader follow the discipline and be absolutely faithful to his plan. There is no question that trading real money brings emotions close to the surface and as I mentioned in the first article in this series, many traders cut profits and let losses run. Without iron fisted discipline we all run the risk of falling into that very trap. When we see a loss, it is very easy to say to ourselves: "It'll come back." We may decide to let it go just another 10 or 15 cents and all too often that becomes $1.00 or $5.00 or more. If we incorporate a specific exit strategy in our plan and pre-determine what will trigger our exit before we enter the play, we have taken one very important step in increasing the likelihood of overall profitability in our trading. We have included a disciplined methodology of cutting our losses.

My observations have taught me that many serious traders "get it" and do establish loss cutting strategies fairly early in their learning curves. It seems, however, that they may find it more difficult to let profits run. Instead, there seems to be a tendency to pull the plug fairly early when a profit is seen and the result quite often is to cut profits as well. Just as there are innumerable ways to cut losses, there are many devices to help let profits run.

One way to let profits run is to use a trailing stop order. As the name implies, we can place an order with our broker that trails behind the movement of our stock price and takes us out when it moves against us at a pre-determined amount. I often use trailing stops in situations where my position is already profitable and I want to put the trade on auto-pilot so that I remain in the position until it reverses an amount that I have pre-determined. For those who may be unfamiliar with the use of a trailing stop, let's look at an example. Suppose I bought shares of my old friend XYZ at $20 a share and the stock has moved up to $22 a share. There is profit in the position and I would like to protect at least some of that while continuing to let the profits run if the upward move is going to continue. I could place a trailing stop, based either on a percentage or on a dollar move down. Suppose I decided to set a trailing stop at $0.75. Initially when I place the stop with the stock at $22 a share, that means I would stay in the position as long as the stock price doesn't fall below $21.25. If it did, I would be stopped out and probably preserve at least some of my gain. On the other hand, if the stock moved up, the trailing stop would also move up. Suppose it moved to $25 a share. Now my stop would automatically have moved to $24.25. In this case, the stop would always move up based on the new highs the stock is making. Similarly, I could have chosen a percentage stop instead of a 75 cent stop. In our example, if I chose a 5% stop, at a $22 share price, initially a drop of 5% to $20.90 would take me out. If the stock went to $25, my stop would now be at a 5% drop from that level or $23.75. Ordinarily, trailing stops are placed good 'til canceled so that they remain in place and profits run until a pre-determined retracement takes place.

In last weekend's article, I suggested that one could use a moving average as a stop loss. Use of the moving average can also assist in letting profits run. Suppose as in last weekend's example, I bought a stock as it bounced up off a 50 day moving average. My initial exit might be on a break below that average, but my whole exit strategy could be to exit whenever the moving average is broken. In general, as long as the stock price is moving up the moving average can be expected to be moving up as well. Thus, as long as the stock price remains above the moving average, my profits continue to run and I continue in the play. It is only when whatever moving average I have chosen is broken that I exit the play. Once again, it is the price movement of the stock that takes me out instead of some emotional reaction on my part. The same methodology can be utilized with a trend line.

Yet another way to let profits run is to follow behind the move with a stop loss order. I often move my stop behind Japanese candlesticks. As the move continues in my direction, I am moving my stop up using the candlesticks. When the move reverses it takes me out rather than me taking me out.

Once again, many of these strategies are quite simple. I am certain of one thing. Their use works better than me listening to that "little voice" inside my head that almost invariably tries to suck me into cutting profits and letting losses run.

As a little review of this series of articles, I suggest the following are major points:

1. Recognize that cutting losses and letting profits run can be instrumental in achieving trading and investing success;
2. Create and implement a plan that fits your own trading personality taking account of your risk tolerance, available time, and knowledge of strategies;
3. Accept that some trades will lose;
4. Include an exit strategy in your plan that has the stock price movement take you out of a position that is going against you and don't rely on your emotions;
5. Include an exit strategy that keeps you in a position as it continues to move in your desired direction, but that takes you out on pre-determined reversals;
6. Understand that discipline rather than emotion must control the exits;
7. Understand that the biggest impediment to overall success may well be you and your reaction to your own emotions.

I hope this series has shed some light on ways how a trader can cut losses and let profits run. Both my books, "Trade Your Way to Wealth" and "Smart Investors Money Machine" include information that goes farther in discussing these elements in greater detail as they pertain to specific strategies, specific investments and to the "how to's" at various stages of an investors life. I hope you get copies and continue the learning process. For those who are really serious about taking the next steps, you may want to consider an intensive coaching session designed for you personally.

As to the blogger who asked for more information on how to cut losses and let profits run, I sincerely hope this information has advanced your knowledge as well as that of other subscribers.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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To comment on Bill's article click on the "comments" link below.


Anonymous said...

This series of weekly articles was very insightful and a good review of some of the material in your books, which I own. Thank you.
John in SC

Bill Kraft, said...

Thanks for the kind comment, John from SC and thanks for buying my books.
Bill Kraft

Anonymous said...

I have enjoyed your weekly articles and I am now thinking of subscribing to your $10 Stock Trader service.

But I would like to know, on the average, how many positions you hold at any one time in the three services that you offer.


Bill Kraft, said...

George, I really don't know the average number. Sometimes I hold none and sometimes as many as 10 or so. My guess, and it is only that, is that I hold about 5 positions at a time.
Bill Kraft

Ken said...

I enjoy your weekly newsletters very much and appreciate the time you put into them. I have a couple of questions:
1) As a relatively new trader, which of your two books would you recommend I read first?
2) Do you use the Fibonacci series or the Elliot Wave in any of your trading strategies?

Bill Kraft, said...

Thanks for writing, Ken.

In response to your question about which book I would recommend you read first, I can tell you that "Smart Investors Money Machine" is designed to have relatively broad appeal and includes a number of income seeking approaches that cover stocks, some basic option strategies, and a number of other investment types such as MLPs, bonds, annuities, and even reverse mortgages. "Trade Your Way to Wealth" is more "trader specific" dealing in depth with things like risk awareness and risk aversion, the specifics of creating a business plan, money management concepts and a number of option strategies from relatively simple to somewhat complex. Having written all that, I guess it is easier for you to decide which may best fit your own needs right now.

In response to your second question, I do look at Fibonacci retracements sometimes in my own analysis, but have not relied on Elliot Wave to any significant extent.

Hope that helps.
Bill Kraft