Let Profits Run

Source: StreetSmart Edge™ as of December 10, 2008 to January 6, 2010.

By far, the most common way to exit a trade at a specific profit target is the use of a limit order to sell the stock at a specific price. With this type of order, the first time the stock trades at or above the specified limit price, the sell order is executed and the position closed. By definition, this means the stock is rising when the order is executed.

The important point to note here is that using a limit order with a predetermined price target goes against the trend-following approach. Because an uptrend is defined as a series of higher lows, the only way for a trend to change from up to down is for price to drop below the most recent low.

The goal of trading is to let profits run as much as possible when you have a successful trade. In my opinion, this means holding the trade until the trend in price has changed from up to down.

Let's revisit the Apple example to explore another method of exiting a trade. In the chart below, we're looking at the early stages of the same Apple trade, with the same entry at approximately 104. After a little over a week of sideways trading between 104 and 110, the stock begins to move higher and is approximately 135 one month later. As the price rises, most traders feel good about their trade and their decision-making.

Selling at the First Sign of Trouble

Source: StreetSmart Edge as of November 11, 2008 to May 13, 2009.

However, as the price begins to pull back, anxiety builds in many of the same traders who just recently were feeling very self-satisfied. From the peak at 135, just five days later stock has dropped to about 120 and mild anxiety turns into full-fledged panic in some cases. An almost irresistible desire to "grab that profit" sets in and many traders sell the stock, locking in what remains of their profit.

Over the years, I've observed that in this situation, very few traders recognize that it's fear driving their decision-making. They mistakenly believe that greed is driving their actions. After all, their objective is to "grab that profit." How could that be fear?

The answer is that we can usually identify the emotion in control of our decision-making by the action that we ultimately choose. In this instance, if a trader chooses to sell the stock, then by definition, he doesn't believe there is any further profit potential and therefore wants to lock in that profit immediately. If the trader believed that the stock might rally further and turn into a larger profit, then the decision would be to hold onto the trade and let profits run.

Let's revisit the Apple trade one more time using the trend-following approach. This approach may help traders overcome their fear and let profits run. In the chart below, you'll see a picture-perfect uptrend as defined by a series of higher and higher lows. I also marked the chart with an initial protective stop just below 80.

The Trend is Your Friend

Source: StreetSmart Edge as of December 31, 2008 to January 4, 2010.

As I mentioned before, an uptrend is defined as a series of higher and higher lows. Once we recognize a higher low, we can raise our stop beneath it.

Of course, this cannot be done in real time. In other words, on the day of a significant low, traders can't tell that is a significant low. This can only be discerned at a later time, after a couple of days have passed and the low becomes more obvious.

Even worse, the only way for a stock to make a "higher low" is for the stock to pull back. And yet it is these pullbacks themselves that lead many traders to "sell at the first sign of trouble."

I find this to be one of the great paradoxes in trading: In order to let profits run, we must be prepared for some of those profits to slip away, in order for a higher low to form and the uptrend to continue. At the same time, we must overcome our fear which the pullback may induce.

Two conditions to consider when exiting a trade

A disciplined trader will usually only exit a trade when one of two conditions is met—and both conditions involve a stop order being triggered.

The first condition is when the initial protective stop is triggered and the trade is closed out at a predetermined and acceptable loss.

The second condition is when a raised trailing stop has been triggered and the trade is closed out because the trend in price has changed. While this will usually occur with a profit, it may result in a loss particularly early in the trade if the stop has not been able to be raised far enough to result in a profit.

Rigorously adhering to these two exit conditions may help you override your fear when a trade pulls back, because they require you to maintain discipline when your emotions start to get the better of you. Keep in mind, there are certainly times when you might make an exception to these two conditions, but in my opinion, they should be very rare.

Coming up next

Next month, I'll explore a method for evaluating your trading results that may allow you to make more informed and less emotional decisions. Until then, good luck and good trading!