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Protecting ProfitsNew traders generally focus all their attention on learning entry skills. What to do after a trade has become profitable remains a gray area for most till frustration sets in watching winning trades turn bad or regretting after exiting too early. In the absence of clearly defined exit strategy fear, greed, and indecision spoil the show. Hence, a proactive approach designed to capture profits before they slip away is a must in order to transform “trading game” into serious “trading business”. Protecting profits is a major issue for the smart money management. The question is: What should a trader do when a position is showing gains of say, 30% or 50% and is still gaining?
The problem with this approach is: once you partially shed a position and it acquires more gains, you can’t gain any more on that portion. So why not stay fully in the trade without allowing gains to slip and yet giving it room to grow further. The solution is: trail the price with protective stops. So, now the real issue is how do we go about placing protective stops? If we trail the price too tightly we risk getting out of a real winner, and if we trail from a large margin we risk losing a large chunk of the gain. The best solution is: let the average stock volatility and the prevalent market conditions guide you. Let us work out an example to understand it better. Assume that we have total trading capital of Rs. 100,000 and we limit our risk to 1% of the capital. We choose to buy a stock at Rs. 100 and we decided to place the stop loss at 8% below the buy price. So our initial position will be as follows: 1% risk of Rs. 100,000 = Rs. 1,000 Assume now that the position is up over 25%. How should we protect this profit? At 25% gain, the current share price = Rs. 125 At this point in time, the trailing stop is at Rs. 115, which guarantees a net gain of 15%, in case the stock changes direction. So, we are risking 40% of our gain in order to stay in the trade for larger profits. The position moves up further and the gain becomes, say 50%. Let us apply the same logic as above to get: At 50% gain, the current share price = Rs. 150 At this point in time, the trailing stop is at Rs. 138, guarantying a net gain of 38%, in case the stock changes direction. So, we are risking 24% of our gain in order to stay in the trade for still bigger profits. The position moves up further and the gain becomes, say 75%. Let us apply the same logic as above to get: At 75% gain, the current share price = Rs. 175 At this point in time, the trailing stop is at Rs. 161, guarantying a net gain of 61%, in case the stock changes direction. So, we are risking about 19% of our gain in order to stay in the trade for still bigger profits. Needless to say, deciding stop level is an art and should not be done blindly. You should factor in the prevalent market condition and stock volatility. Longer term investors should use wider stops while shorter term swing traders should make their own rules that make more sense. Day traders, whose positions last only few minutes to few hours, may like to base their actions on the intraday support and resistance levels. While the above outline of a winner trade may appear too simplistic and straight forward, common sense should not be allowed to go in oblivion. There are chart patterns and technical tools that help spot trend reversals – their messages can also be utilized. The idea is to capture the maximum profit and not to get off track following some idea mechanically. If the indicators are suggesting a strong possibility of trend reversal, then you may like to take all the available profit and exit. Divergence between the price action and indicator signal is a valuable tool for spotting eminent trend change, particularly in the oversold or overbought region. Appearance of certain candlestick patterns, such as a “doji” candle, when other indicators such as slow stochastic or RSI are in overbought or oversold region should alert you for a probable exit. Parabolic SAR is another straight forward and unequivocal indicator. When several indicators point to an eminent trend reversal, get ready to exit rather than keeping busy adjusting trailing stops. |
Some times you are advised to exit in smaller quantities, if the trade size allows. For instance, you may offload 40% at the first price target, another 40% at the next price target and let the remaining 20% hit the trailing stop. Following similar reasoning, you may get rid of a third of the position around 35% profit, another third around 70% and stay with the remaining third until you find trend changing. But, is this the best way to manage your positions?