A Technique for Profit Taking

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.
HOW?

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.

100407_fslr_profit.png

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
Risk: 1%
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%

If you are unsure of how I came up with the numbers in this example, please take the time to visit my position sizing calculator and the post titled: position sizing and expectancy.

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?

    Scenario #1:
    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%.

    Scenario #2:
    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:

    Scenario #3:
    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.

  • A trend trader using 25% retracement stops in BIDU would have been sold near $190 for an 80% gain. They would have reestablished their position near $200 and would still be holding with a stop above $290. See the chart below:
  • 100407_bidu_profit.png

    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!

    Comments

    1. 2 questions about this method:

      #1 Does this method only calculate profit based on closing price?

      In the BIDU example, the original 4/25 position would be up 28% at the 4/27 high A 25% profit retracement stop based on the high would be 125.47 and you’d be out of the position with a 21% profit.

      Not bad for 2 days – but would you rather be in for the subsequent run?

      Many would prefer to have this question answered when the position is established – what are you in it for, what’s the goal?

      This leads to #2: The method above appears to ignore the timeframe involved.

      If your hoping for 20% gains over say 3 months, what do you do if they happen in 2 days? Do you change your plan? What if the position is flat for 3 months – do you bail?

      The timeframe involved determines the type of investor / trader you are – a plan that doesn’t include it is not much of a plan.

      Keep up the good work!

    2. D,
      For me, I use closing prices and end of the day data for all of my personal research. However, this can vary from person to person. I trend trade so I am looking for gains over a longer period of time. I prefer profits in two weeks rather than two months but both are fine by me.

      As far as time frames: I only place a time frame on a stock based on a lack of a profit. For example: I place a position in XYZ and expect a move based on a catalyst within 4 weeks but it goes no where after 6; I will sell it and place my money elsewhere if there is a better opportunity (risk/reward).

      When trend trading, there is no hope for a gain in a specific period of time. You just play defense against a stock that doesn’t move within a specific period of time (for me, 3 months or so –discretionary analysis is involved as long as stops are not triggered).

      Take MR for example. I loved the stock and bought it but it did nothing for three months. I did sell and then it doubled. Had I waited for one more month, I would have caught the gain. It didn’t matter (in this case) because that money went into MA and BIDU.

      So to answer your question, yes I do bail if it stays flat. I don’t day trade and I don’t consider myself a swing trade exclusively. I look for longer trends. I do swing trade when certain opportunities arrive.

      You must set time parameters and adjust your stops (if they are profit retracements or std deviations, moving averages, crossovers, oscillators, etc…) based on your objective.

      Hope this helps. Read around the blog, some of your questions are answered in other posts. I can’t cover everything in one post, no one would ever read the whole thing.

    3. When you set up your stop loss, do you consider other factors such as 50/200 day moving average? For example if you entered a position near 200 mavg(but still below 50 mavg) and it gained 30%(now it is above 50 mavg and its calculated stop loss also above 50 mavg), would you still use your calculated price even considering the stock may have support at 50 mavg?

    4. teapot,
      Yes I would. I use the 50-d and 200-d moving averages mroe so than any other buy and sell tool. This post just offered another technique for taking profits. it is not an end-all, be-all technique. Just another tool in the shed.

      The 200-d m.a. has been a bread and butter buying technique this year for CANSLIM type stocks (on pullbacks).

      In your example, I would use the moving average over the profit retracement. Institutions and market makers use these levels to flush out retail sellers with stop losses.

    5. Hey Chris, I wanted to give you an update on this position you mentioned sometime ago which you may have forgotten, but I hope you did not.

      I originally got a position on this stock on July 10 at $15.10 based on your original analysis and my own research. I realize after you further analyzed it that the entry was incorrect but the cash left on the table was a forgone conclusion so I remained in the position.

      Since then, the most the stock dropped was 12% which should have kicked me out. Although, I decided to stay in due to the lack of volume on the decrease in price.

      I can say that you have another winner on your hands. In the last two days, the stock has risen 15% on heavy buying (a great sign as you know). I see your initial targets as easily reachable and maybe some more.

      Let me know what your re-evaluation of this stock is if you choose to do one.

      I also wanted to ask you regarding a stock you originally looked at that went past your ideal buy position, GTLS. It looks like it is currently taking a breather and forming a handle. What are your thoughts? Do you see establishing a position here if you did not catch it at original target price of $28?

      Thanks again for your thorough research and the valuable info you provide. Keep up the great work!

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