Connors’ Weekly Battle Plan
How To Lock In
Profits (plus, adventures of a Little League softball
manager)…Part 2
Last week we looked at three ways to lock in gains when you have them. This
week, let’s look at some examples to help us further understand this process
(and, incredibly, I’m still not an “idiot” Little League Manager (see
last week’s column). But, that will end for sure this Thursday night when we
have our first scrimmage game. With 8 All-stars on the team, and only six
infield positions available, I’m sure at least two parents are going to shoot me
when I tell them their child is playing in the outfield and hitting near the
bottom of the line-up. Ugh!!!).
Looking At The
First Rule
1. You Need To Lock Pieces In
Last week we discussed how important this is. You can live in one of three camps
here. Two are correct and the third is wrong.
The third camp (the wrong camp) is that you just exit your entire position as
soon as you have a small gain. My guess is you will never be able to make money
in the long run with this approach. Your gains will be too small to overcome the
losses. In order to have a chance to be long-term profitable, at least some of
your position must be given the opportunity to run.
The other two methods are the better ways to proceed, as they allow you to
potentially capture big moves. The first is that you look for outsized gains on
all your trades. You’re either going to capture a big move or get stopped out.
You realize that the volatility of your portfolio is going to be high and that
you are willing to assume large swings in the value of your account in order to
have the potential to be there when these big moves occur.
Today I spoke with (for the first time) a successful hedge fund manager who
trades that way. He is highly intelligent and systematic in his approach and
truly understands what he’s doing. He has big returns many months (and years),
but along the way he has had some big drawdowns. On a net basis though, his
yearly returns have been tremendous. This is how he goes about his business, and
he’s fully willing to assume the responsibility (and pain) associated with the
drawdowns in order to potentially be there for the bigger moves.
The final camp is the one that I’m most comfortable with. It does not mean it’s
better than the previous camp. It just fits my personality better. I like to
lock pieces in along the way. That means when a position becomes profitable, we
systematically scale out of a position. Our feeling is that you do not know
ahead of time if this, nor any trade, is going to move substantially. Therefore
we play it safe. We start taking profits at specific levels that are
pre-determined before we go into a position.
Here’s an example to look at. Here is a
Windows set-up in
eResearch Technology Inc. (ERES) from this
past week.
                                                                                 Â
Charts by QCharts
As you can see, ERES has a nice Windows pullback in a strongly uptrending
stock. Now let’s move to the next day.
                                                     Â
The stock gaps higher Monday morning, triggering the long Windows set-up.
As you can see, the stock moves higher through the trading day. Now, we don’t
care how pretty this set-up looks or just how high we “think” (actually I
should say “guess”) this stock is going to go. We start locking some gains in as
it moves higher, no matter what. And the higher it goes, the more we lock in. At
the end of the day, the chart looks great, and some people may say we
were foolish to have taken some profits on such a strong moving stock
(hindsight is 20/20) but that’s the way we go about handling a trade. We do the
same thing for every trade.
Now let’s go to the next day.
Before you look at this, go back and look at the chart from September 8. Look at
that close. Look at the follow-through from this pullback. It’s perfect! You
would think today has to move higher, right? Well, maybe. Maybe, because there
are “no perfect set-ups.” I don’t care what a chart looks like, nothing has to
follow-through the way it’s supposed to follow-through. And that’s why you use
stops and it’s why we scale out of trades. This day (September 9) should have
been higher. If there really was heavy momentum buying behind this stock, it
should have carried through. It didn’t. And because we also use a time component
to every trade (we scale out over a three-day period) we want to potentially
lighten up further here. If the follow-through is done, our exposure is
lessened. If it continues tomorrow, we’ll be there for a piece of it. It’s that
structured, and it’s that simple.
Now let’s see what happens the next day (this past Wednesday).
Son of a gun. The momentum really did stop. On Monday night it looked like this
was going to land in the “big gain camp” and unfortunately Tuesday and
Wednesday fizzled out. But, the trade was profitable. Profits on a piece locked
in on Monday, more locked in on Tuesday, and Wednesday we’re out completely.
When you trade like this, you continuously and systematically take gains off the
table when they exist and put them into your account.
The drawback to this approach? You miss the few times a quarter that positions
go on a tear. And the stock of which you sold a piece for a one-point gain and
two-point gain goes on to have a five-point gain or more. And you may (at best)
be there with only a small position. Just as many successful traders are willing
to assume greater risks to achieve greater gains (as the gentleman I mentioned
earlier), many other successful traders are willing to risk missing bigger gains
in order to lock multiple profits in.
Finale
As I said earlier, there is no “better way” with these two methods. You need to
choose the one that fits your personality. Just make sure you don’t jump back
and forth. Much of trading success is consistency in execution and that’s what
you’re shooting for in your profit taking.
Next week we’ll continue to build on this concept.
Have a great week trading (and if you don’t see
my column next week, you know I was nailed Thursday night by an irate Little
League parent)!