A Primer On Taking Profits
The
market has continued to slide the last few days. Distribution
has been very evident in the Nasdaq, and while the S&P and Dow have fared
better, it has been a difficult environment to be long growth stocks. As I normally
do at the end of each month, I will be giving a detailed market overview on
Wednesday. For now I’ll just say that I would continue to play any new
trades close to the vest and make sure you’re not being too liberal with your
stops.
What I really want
to discuss today is profit taking.
Deciding when to sell and take profits is normally the most
difficult decision that traders face. It is also the decision that is most often
second-guessed. Should I have held on? Should I have sold sooner? Should I have
scaled out?
Compared to selling, buying is easy. For any trader that uses
technical analysis, buys are made when a pre-defined trigger point is hit. “If
this happens…buy.†Rarely do I hear traders second-guess their buy
points. This is because whether a trader looks to enter on a breakout, a pullback,
a crossover, or some kind of oscillator signal, the rules are normally well
defined.
To take the second-guessing (and subsequent mental anguish)
out of profit taking, traders need to have sell rules as well as buy rules.
The key is to structure your sell rules in a way that you can comfortably follow
them. If you can’t comfortably follow them, you’ll end up breaking
the rules and second-guessing yourself anyway.
The first thing to understand when determining your profit taking
rules is that you are never going to sell at the top. There is no method that
will consistently allow you to get out at the very top of a move. That’s
a reality. There are two ways to deal with it:
1) You can sell too early
2) You can sell too late
These are your only choices. Today I will talk about the pros and cons of each.
Next week I will expand on this theme and discuss how it is possible to mix
methods to achieve your ultimate comfort level.
Selling too early
Traders whose sell disciplines call for them to sell too early never wait for
a confirmation that a top has been made. Instead they look to take profits either
when certain targets are hit or the trend’s momentum begins waning. Here
are some things to consider when using a “sell too early†discipline:
Pros
1) When selling too early it is much easier to get a good fill. This is especially
true for larger positions. Unloading stock is a lot easier when the price is
moving up than when it is moving down.
2) By selling too early, your account will be less subject to large drawdowns.
You’re not waiting for the top to confirm itself and therefore won’t
have to suffer through watching a position that was once a big winner reverse
and stop you out for a small gain or loss.
3) Your capital will be hung up for shorter periods of time. By taking your
profits earlier rather than later you can put that capital back to work in your
next trade.
Cons
1) You are significantly reducing the chances of a “home run†trade.
If after you sell the security continues to move in your direction, you will
miss out on that part of the move. This can be especially notable on big moves.
2) You will be more prone to shakeouts. A “sell too early†mentality
means using profit targets and tight stops. The tighter the stop, the more likely
you will be shaken out of a move before its completion.
An example of a trader that consistently and successfully uses
the “sell too early†discipline is Larry Connors. Larry’s
methods call for him to take profits as certain targets are reached, and continue
to scale out over a number of days as the position moves in his favor. His CVR
signals can catch major market swings as well as minor market swings, but his
sell disciplines do not call for him to wait and see if the swing will be major
or minor. Rather he looks to take what the trade gives him in over a period
of several days and then moves on to the next trade.
^next^
Selling too late
Traders whose sell disciplines call for them to sell too late are looking to
make sure that that they ride the trend for all it is worth. They don’t
want to see their position go on to huge gains without them and will do what
is necessary to ensure that the move is over before they exit their position.
This is most commonly achieved through the use of trailing stop techniques.
Here are a few pros & cons to consider about selling to late.
Pros
1) “Home run†potential. It’s impossible to know how long
a trend will last. Some trends can last a long time and allow an investor to
realize incredible gains. Traders who decide to adhere to the “sell too
late†discipline have a chance to make huge profits on any trade.
2) Less prone to shakeouts. By using looser stops you will be less affected
by all the noise and more likely to be able to hold a position throughout its
move.
Cons
1) Subject to larger drawdowns. Sometimes a stock can fall pretty far before
a top can be confirmed and the previous trend declared dead.
2) Capital is hung up for longer periods in each trade. Sometimes it can take
a very long time before it can be determined that a position has topped out.
During this period of time, you would normally be better served to have your
money invested elsewhere (or in cash).
3) Sometimes difficult to get a good fill. If your stop happens to be placed
near the stops of a lot of other people your chance of getting a good fill are
significantly reduced. This is especially true for large positions or thinly
traded stocks. Due to this, your trades will have higher slippage costs.
An example of a trader who consistently and successfully “sells
too late†is Mark Boucher. Mark will never sell at the top, but he will
capture a large portion of the move and will realize fantastic gains on some
of his trades.
There is no right or wrong here. You can sell on the way up,
or you can sell on the way back down. You can make money either way. Larry and
Mark are proof of that. What’s difficult (near impossible) to do is consistently
make money by arbitrarily selling without a discipline in place. I’ll
expand on these thoughts and discuss some of my preferences for taking profits
next week.
Until Wednesday…good trading,
Rob Hanna
robhanna@rcn.com