Use a stop, don’t use a stop. Make it a hard stop, make it a mental stop.
What do you do in a market like today when you have profits in multiple positions but you don’t want to give it all back? You want to continue to ride the winners but at the same time, you want to maintain the unrealized gains in your account.
Most investors and many more market pundits continually talk about setting stops; they range from physical stops to mental stops to trailing stops to support stops to retracement stops or even moving average stops. It is easy to set a mental stop before you enter a position based off of your money management rules such as position sizing and expectancy but will you do it.
If you have a $100,000 account and want to risk 1% of the account on a $50 stock with an 8% stop; we know that the trade will allow you to buy 250 shares with a worst case scenario sell stop of $46.00 (assuming a 1-R risk of $4). This is wonderful but what should a trader do once the position gains 20%, 30% or 50%?
Where should the profit-taking-stop be placed? We want to eliminate the chance of losing the unrealized gain without cutting the stop too tight. We don’t want to sacrifice our possibility of riding a real winner, otherwise known as a home run stock (a 10-bagger as Peter Lynch calls them)! Loosen the stop as you feel comfortable as longer term trend traders will allow for larger swings and draw-downs from peak gains. Shorter term swing traders may agree with the tighter retracement stops explained below.
Many books attempt to explain how to take profits and several academics offer advice but most of it is fluff and biased to opinion. I have heard traders claim that they take a third of the position down after making a 20% or 30% gain while other traders take down half the position once a gain reaches 50%; but is this the correct way to manage money and positions?
Keeping things simple, we could implement a combination of a trailing stop and a retracement stop based upon the actual gain at any point in time. In a bull market (like 2007), I will allow the system to loosen itself so I can handle a healthy pull-back without selling before a possible larger move. I would increase the size of the profit retracement stops when things are trending higher on a weekly basis. Let’s focus on a method for locking in profits without giving back too much as a swing trader.
For the sake of this example, I will continue to use the trade suggested above as the round numbers should be easy to follow.
Account Size: $100,000
Stop Loss: 8% (varies based on risk/reward setup)
Share Price: $50
Shares to Purchase: 250 or $12,500
Sell Stop: $46.00
Worst case loss: $1,000 or 1%
Assume we place a position and it is up over 20% after the one week of trading. What should I do to protect the profit I have already made?
At $60, I will set a stop based on a 30% profit retracement.
To do this, you need to multiply the profit of 20% (or $10) by a 30% stop: $10*30% = $3
At this point in time, I will look to close the position and lock in gains if the stock drops more than $3 from the $20% threshold ($60 in this case). My trailing stop is now $57 which guarantees me a total gain of 14%.
At $65, I will set a stop based on a 25% profit retracement.
As my profit grows, my stop tightens so I don’t give back too much. Again, this can loosen in bull markets and is also subject to longer term support and/or resistance lines. For the sake of this article, we will ignore all other variables.
To do this, you need to multiply the profit of 30% (or $15) by a 25% stop: $15*25% = $3.75
At this point in time, I will look to close the position and lock in gains if the stock drops more than $3.75 from the $30% threshold ($65 in this case). My trailing stop is now $61.25 which guarantees me a total gain of 23% if the trailing stop is violated.
Let’s do this one more time with a 40% gain:
At $70, I will set a stop based on a 20% profit retracement.
As my profit grows, my stop tightens so I don’t give back too much. As you can see from the three scenarios, my profit retracement has dropped by 5% as my profit has risen by 5%.
To do this, you need to multiply the profit of 40% (or $20) by a 20% stop: $20*20% = $4.00
At this point in time, I will look to close the position and lock in gains if the stock drops more than $4 from the $40% threshold ($70 in this case). My trailing stop is now $66 which guarantees me a total gain of 32% if the trailing stop is violated.
Longer term trend trading investors will use wider stops while shorter term swing traders will substitute numbers that make more sense based on your own system and money management rules.
Outside of these selling rules, I also employ additional selling rules that use the long term 200-day moving average and long term support levels and trend lines. In a bull market, I will loosen the tight stops and look for longer term sell signals such as the moving average, a channel breakdown or even strong volatility movements that don’t agree with the overall pattern (these may be obvious reversals on the daily and/or weekly charts).
Whatever the case may be, the idea is to capture profits while allowing them to grow within a reasonable risk/reward money management system that you have developed. Only you know what your objectives are, design a system that will allow you to achieve them!