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Monday, 16 January 2012

How to capture trading profits

How many times have you let an unrealised profit turn into a loss? If that has happened to you, you might need to learn how to implement your trade exit strategy reliably.

Click here for the PDF version with images, or read the text only version below.

Trade exit strategies to capture profits reliably
Nils Marchant
October, 2011.

How many times have you let an unrealised profit turn into a loss? If that has happened to you, you might need to learn how to implement your trade exit strategy reliably. There is an old adage: “Never let a profit turn into a loss”. This simple rule is ever so important for successful trading.

If you do not always implement a reliable exit strategy, your trading success will be far from what it could be, or should be. Your profitability will be unreliable. You will tilt the odds of success against yourself. That can lead to greater losses, unhappiness with your trading performance, and even a lack of self-confidence.

Why You Need an Exit Strategy

You only make profits by exiting your trade: never before. By applying your exit strategy reliably on every trade, more of your trades will be profitable. Your profits will tend to be larger. Over time you will become more successful. And for losing trades, your losses will tend to be smaller. Emotion will no longer pollute your decisions. And you will never allow an unrealised profit to turn into a loss.

You need to have full confidence in your exit strategy. Because I trust my exit strategy, it is psychologically easy to implement automatically on every single trade. You should never experience doubt, confusion, or hesitation.

The Three Phases of a Trade

Every trade has three phases: entry; management; and exit. Each phase will have its own exit strategy. Your trading will be more successful if you let profits run, and cut losses short. That means you must always define where your forecast is wrong, before you open any position. As soon as your forecast is proven wrong: close your position immediately. Salvage what remains. You no longer have any reason to remain in that trade.

Stop losses define when you must exit your trade. I use three stop loss methods, one for each phase of my trades:

entry stop loss, set prior to opening the position;
trailing stop losses, set as the trade moves in my favour; and
profit stop losses, to capture profits after reaching my waypoint.
I always set my entry stop loss before I open my position. For bullish trades, I set it at one per cent below a recent significant swing low on the daily stock price chart. If the stock makes a daily closing price below that entry stop loss, I exit immediately the next morning. My forecast was wrong: the stock is going down, not up.

If the stock moves up as forecast, and if I am not stopped out at my entry stop, I ratchet my trailing stop losses upwards one per cent beneath subsequent swing lows. I only ever ratchet them upwards. The ratchet effect reduces potential losses, and then locks in increasing profits. My trailing stops are also triggered by a daily closing price. Any daily closing price below a trailing stop loss triggers exit the next day.

Your Trade Waypoint

You must also estimate where you reasonably expect the stock price to go to. You must decide in advance how you will exit your trade to maximise your profits when you reach your waypoint. When your trade reaches your waypoint you need to implement your exit strategy with strict discipline. It is not a good idea to simply exit the trade when you reach your waypoint. It is better to remain in the trade as long as it continues to run in your favour. But you should get out of your trade at the first sign that the market is putting your unrealised profit at excessive risk.

When I reach my waypoints I use much tighter exit criteria, which trigger exit more readily. Having had a run up, the stock is more likely to turn down than continue up. I only stay in my trade while the stock continues to move up. Each day I shift my profit stop loss upwards to the intra-day low. As soon as the stock trades below yesterday’s low, I exit immediately, for, by definition, the stock has turned down. At that point there is a bigger chance that the stock will continue down than continue up.

Setting Your Profit Stop Losses

The market gives you many clues that your unrealised profits are at increasing risk. Profit stop losses capture unrealised profits at risk. You could use any one or more of the following criteria to exit to take profits. You could exit:

as soon as the stock price turns against you;
as soon as a trend line is broken;
as soon as a price support level is broken; or,
as soon as a simple moving average is broken.
Each of these conditions warns you that your trade has probably run its course, and that your unrealised profits are probably now at greater risk. If all of those criteria are met: you should definitely close your trade!

In addition to this standard procedure I might also overlay other stop loss strategies, based for example upon price chart patterns, indices, options premiums or time. For bearish trades I simply invert the process.

If you manage your exits in this way you will let profits run, and cut losses short. And that should prevent you from ever allowing an unrealised profit turning into a loss.
To learn how to trade stocks, CFDs and options, contact my colleague Paul Wise at Options21.  To start your options trading trading education program you can get our free options trading education CD, if you wish.

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