Letting Your Profits Run
This is a trading mantra that you will hear time and time again in all the books or trading courses that you will ever read or attend. What exactly does it mean?
The detail of this has been looked at in previous trading articles but to summarise, it means that if you have a profit on a trade, you should let it run until it loses steam. The time it loses steam is also the time to exit from the trade.
The problem is that when the trade starts to lose steam, it will inevitably start to decline in price. This means that the best time to exit is not actually at the “top” but a little bit after the top has been made when the share price is slightly lower. The diagram below shows this in a little more detail.
As can be seen above, there is a small gap between the top and the exit point. This means that you will have to give up a small proportion of the profit you have made when the trend starts to decline.
A top is very difficult to exit at. It requires great skills of technical analysis and even then there is no guarantee that you will be right in your trade. Worse still, you will be kicking yourself if the trend were then to continue upwards after if you had just exited at a point that you thought was the top! The best way, therefore, of exiting a position is to wait until the trend has changed and then, using your trading system rules, exit at a point lower than the top. This does mean that you will be sacrificing some of your profit but in the long run, your trades will be much more profitable. You will be letting your profits ride upwards until something tells you to get out.
Cutting Your Losses Short
We have now discussed the best way to make a profit – but what do you do if you start making a loss?
Again, as stated in previous trading articles, you will inevitably make trades that lose. This does not mean that you are a bad trader, it just means that the markets decided to not work in the way you expected!
What will make you a bad trader is if you decide not to get out of a trade that is going very wrong! This is where having a stop loss in place is essential. A stop loss will get you out of a trade without you even having to think about it if it all goes wrong!
A stop loss should be placed below your entry point at a point where, if the characteristic of the stock were to change for the worse, you would be able to get out as soon as possible. You do need to make sure that it is not too close to the entry point or otherwise you risk getting kicked out of the trade too early.
There is no ideal stop loss method for all situations but the ideal characteristics of a stop loss point should be to place the stop loss at a point not too low to cause excessive losses and also at a point to allow room for the trade to breathe a little.
The diagram below demonstrates this:
It can be seen that the very tight stop loss (1) would have been triggered too early and the trader would have been kicked out of the trade before the trade had a chance to go up.
Stop loss (2) on the other hand was placed at the right point and was not triggered prematurely. The trader in this situation would have been in the trade when it started to go up.
A Common Issue
Finally, this trading article concludes with the following message. Human instinct is to do the exact opposite to the above. Most traders when they start to trade do the exact opposite i.e. they let there losses run and cut their profits short. You have to do the exact opposite to what nature has wired you up for – and that is a difficult task. With conscious effort and training, you will eventually succeed!
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