How far can you push your profits?

Novice (and not so novice) traders are often criticized for taking profits too early, while leaving their losers to run.

But, of course, leaving profits to run isn’t just about ‘having the nerve’ and ‘not buckling under pressure’ – as some macho trading speak would have you believe. It also involves plenty of occasions when we watch perfectly good profits dwindle as the price turns tail and gets stopped out.

So, how do we know how far to push it? And how far is too far?

Calculating reward based on risk

This is the simplest route. We’ve carefully calculated our stop position, and we expect a certain return for that level of risk.

This approach is a decent one. It focuses on risk levels, it balances reward with risk, and it’s nice and simple to calculate. The value of simplicity shouldn’t be underestimated – with trading, we’re often making quick decisions under pressure, so a simple calculation that give us a sensible target can be very valuable.

However … this one-size-fits-all approach can leave us with targets in odd places, like just above a round number, or just below an area of support. These are levels that prices will have to work that bit harder to hit, so we’re making success that bit tougher.

Which is why the next method will give us smarter targets (albeit for a little extra work) …

Adding technical analysis

There are a number of technical tools we can use to position profit targets. I go into details on my preferred ones HERE.

There are two key technical factors we want to take into account – areas of support and resistance we could butt up against, and the ‘legs’ of the market – how far is a reasonable expectation for price to go?

Fibonacci extensions, average true range and pivot points can all help with these, as I show in that post I linked to above.

But my hands-down favourite tool is a glance to the left.

Take a look at recent price behaviour – are there any support or resistance levels apparent, or areas of consolidation that the price has struggled to move through in the past? This is one of the most powerful predictive tools for how prices will behave in future.

Closing too soon

At one time I worked with a trader who would take any profit off the table. The moment his trade went into profit, he’d close it. His approach was, that if he could make a tiny profit on almost every trade, he could afford to weather the occasional big loss.

While there’s a logic to this, it runs up against some serious practical problems. The first is trading costs, which immediately tip our spread bets into a loss the moment we open a trade. If you’re holding short-term positions especially, costs are a considerable proportion of your trade, and this is starting off the race by first having to climb out of a hole.

Which brings me to my second issue, which is more anecdotal. Losing trades often NEVER show a profit. I expect you’re familiar with this – the bad trades that immediately move into a loss, and never poke their heads into profit. This is because we don’t generally position our entry levels at random points on a chart – they are usually just above an area of resistance, or below an area of support.

This means that it’s not unusual for prices to just poke their noses through these levels, before turning tail.

It’s not that there’s necessarily a problem with the entry – sometimes markets just don’t do what we want them to. But it means that prices don’t randomly swing around our entry levels offering these small profits as often as you’d need for this strategy to work well.

It’s an extreme example, but being too modest with our profit targets can set us on an uphill struggle to success. There are some trading styles where tight targets work, but if you’re trading in the direction of the trend, then you really should get more ambitious …

Pushing the envelope

Markets trend, they consolidate, and they correct. Market trends are, for most traders, where we want to collect our best profits.

I find it helpful to think of each little market trend as a mini bubble. Yes, there may be areas of consolidation, there will be corrections, but there will also be that strong feeling that ‘Surely this has run far enough? It can’t keep going?’

The reality is that trends often run much further than value or technical indicators would suggest. If that wasn’t true, then overbought/oversold indicators would work a lot better than they do!

And that’s why trend traders must be ambitious with their targets to ensure long-term success.

But, as I pointed out earlier, when we let our profits run and run, some of the time we’re rewarded with incredible returns … but some of the time we watch those profits evaporate as the price reverses to our stop level.

Psychologically, this is one of the toughest parts of trading.

The imperfect tool I find helps me with this is the trailing stop. By knowing that I’ve capped risk, and even locked in some profits, I’m much more comfortable pushing for ambitious targets.

I’m not keen on arbitrary trailing stops that just follow the price, but prefer to position mine just outside key levels as the profits creep upwards. You can find out more about the techniques I use HERE.

Building good profit-taking habits

Balancing risk with reward, leaning on technical analysis for help, and being ambitious are the three key considerations in positioning your profit targets. Blending these together doesn’t need to be complex – we can easily build simple habits that you work into your trading.

In the coming weeks I’ll look at how we put tools and good-practice together to build simple rules that are easy to follow.

 

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