Wednesday, November 19, 2014

Letting your profits run

Last night I had the pleasure of a conversation with a trader about his performance and where he needed to improve. His trading story to date mirrored my own early days - starting off on day trading on very short timeframes before moving to the daily timeframe, along with trying to adhere to the principle of following trends - cutting profits and letting profits run.

He doesn't have a problem in taking small losses. He also only risks a very small percentage of equity on each trade. He has never blown up an account. In those respects he is ahead of 90% of traders out there. He has been trading for a few years now, yet he is only about breakeven in his overall performance.

This trader is very close to making the breakthrough to overall profitability, but there is one element missing - the inability to let his profitable trades run.

This is quite a common occurence, particularly with people who want to follow a trend following approach.

After discussing this, it became apparent there was an element of fear about seeing open profits evaporate and disappear, or worse still turn into losses.

He then went on to say that, occasionally, he did make a decent profit, normally as a result of being unable to been in front on his PC and watch the markets!

For some people, letting profits run is a major battle - they may lack the patience to let the winning trades play themselves out. They are so anxious to bank a profit that, at the first sign of a price consolidation or minor pullback, they try and be 'smart' and time the exact top of the move. They may be right once in a while, but doing that soon gets annoying when a few days later the stock is powering up to new highs and beyond.

There are a number of things you can try to do to help you let profits run:
  • Once you have updated your stops based on your own rules, and placed any orders to open new trades, switch your PC off and do something else.  You can't influence what happens, you know your risk and you have stops in place - there's nothing else you can do;
  • You need to develop the feeling of emotional indifference towards each trade. If you are unable to do this, then that suggests you are risking too much of your equity on those trades;
  • If you do watch the markets during the day, try removing the price candles from your charts (yes, really!). Even daily price candles are noise to a trend follower. Look at this post for more;
  • Focus on the process, not the outcome - traders I know have tried things like re-configuring their trading platform so they cannot see what their current profits/losses are;
  • I've advised one or two traders to even remove their trading apps from their mobile phone, so they avoid keep checking positions during the day and possibly making snap decisions they may regret.
With a trend following approach, as the win rate is typically below 50%, you need those big winners to cover all the small losses made and generate the overall profit. Therefore, to generate the overall positive expectancy to make it worth your while, having the ability to let those profits run is a key element to achieving success.

If you are familiar with the story of Richard Dennis and the Turtle Traders, then you may recall that the group went through this on their very first trade in Heating Oil. Of those traders, only Curtis Faith didn't try and second guess what has going to happen, and kept his full position open. As a result, he was the only one to make a significant profit on that trade, and the group got a very early taste of how psychology plays a major part in trading.

Once a trend follower is in a trade, there is usually only one price level that he needs to worry about - where his trailing stop should be placed. If you are in as long trade, then the market can move around as much as it wants providing it doesn't violate that stop level. You can't control it, so why worry about it?

There are only three instances where you may want to consider cutting profits short:
  • If  a stock you have a position in suddenly announces an agreement on being taken over at a premium on the current share price - you may as well close the trade when price gaps up, bank your profits and move on;
  • Depending on your approach to risk, timeframe etc., you may want to close part or all of your position when a scheduled earnings release or trading update is due to be announced;
  • When price move extremely aggressively in your favour, and your trailing stop is left far behind. When this occurs, your open risk may be significantly larger than your original risk on the trade, and you may want to re-balance this. I refer to this as using the Uniform Risk Exit (more on that here).
As was seen in this case study, this element is often the last building block required before someone gains true confidence and belief in a trend following approach. I am sure the trader I spoke to last night will also achieve this.

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