The false trading rule that could be losing you money
It’s one of those trading truisms that everyone says: “Cut your losses and let your profits run” – but it could be the worst advice you’ve ever had.
We’ve all seen those trades, where the market shot off just after hitting our profit target, and could have given us another 20 … 30 … 100 pips profit. If only we’d had the guts to let our profits run, right?
Sure, it sounds tempting, but these occasions are very rare.
I don’t know about you, but I remember summer holidays from my childhood as a long stream of endless hot days? The reality, however (growing up in the UK) was very different. But it’s those ice-cream days that stick in our minds, not the ones when I was mopping about the house, complaining about being bored.
And it’s the same with these “dream profit run” days – they stick in our minds, as easy profits we should have taken.
In reality, markets give us a free run like this about as often as you hit all green traffic lights driving down the Euston Road.
Markets have average daily ranges for a reason – they tend to move about the same amount each day, and if we’ve taken our share of profits, we should bank them and be grateful for them, rather than dreaming that ‘today will be the day’ …
The problem with letting our profits run is that it goes hand-in-hand with poor closes, and we’ll often end up giving back a share of the profits that we gained. Over the years, I’ve tried many, many times to use trailing stops to boost my returns, yet, again and again, I fail to see an improvement in performance with them.
So, our mantra should be ‘take profits’ … ‘take profits’ … ‘take profits’ …
This naturally leads to strategies with lower reward-to-risk ratios – so our average winners will tend to be smaller than our average losers. And long-time Bulletin readers will know that risk-reward ratios are another area where I believe that ‘trading wisdom’ handed out on internet forums gives us bad advice. (You can read my opinions on it here.)
So, we need to stop obsessing about letting our winners run. Instead, we need to consider the average range of the market we’re trading over the timeframe we’re trading – and find an intelligent profit target.
And when we’ve secured that profit, we bank it.
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8 comments
Phil
Big thumbs-up from me on this one. For many years I’ve been earning a consistent living through following the exact opposite of this rule – I cut my profits, and let my losses run until they get back into profit. And there are a couple of other golden rules I’ve shrugged off along the way too, like ‘never try to catch a falling knife’, and ‘always use stop losses’. For financial assets which have a tendency to be range-bound, these rules damage profits. The one golden rule for me which offsets all of the above is simply ‘keep your position sizes small’. Small positions mean small risk, less stress and P&L volatility, and enhanced diversification. And it’s amazing how much money you can clock up over time from a rolling basket of small positions.
Phil
Actually, here’s another one – ‘never chase losses’. If my trading system endorses it, I’m happy to chase losses back into profit by doubling up on them sometimes. As the initial position size was small, I can do this without getting into trouble.
Paul wilson
Hi Mark and Group members,
Like it says in Ed Seykota’s ‘Whipsaw Song’ – you take a whip and I take a saw but one good trend pays for ’em all.
My approach – 2% Rule – calculate max risk and hence the max number of contracts you can trade.
Example with 3 contracts.
1st profit Tgt = 10 ticks. Lock in profit and reduce Risk with two (2) contracts to go. Leave Stop alone.
2nd Tgt = 15 (10 + 5). Ditto above with one (1) contract to go. Adj Stop by 10 ticks fm original value.
3rd Tgt = 20 (10 + 5 + 5). Your out with 45 ticks profit in the bag and you’ve minimised Risk along the way. Admittedly, not good as 3 x 20 but it’s better than 3 x 10.
Now, assume your a/c has grown – the 2% Rule means you have ‘earned the right’ to trade more contracts.
Example with 5 contracts
Ditto above, 4th Tgt = 25, 5th Tgt = 30. Take 5, and switch on PSAR indicator on a 5 min Chart (Day trade) to get stopped in profit. It has a major benefit too – psychological – it helps control emotions – exiting too early when there’s a good trend in place!
There are some minor nuances to this approach but that’s the essence.
A reasonable compromise between letting your profits run and minimising your risk?
Regards
Paul
Phil
Yes this is smart. If something seems undervalued, I’ll buy it, and then unwind it piecewise as it approaches target, just like you suggest. And sometimes buy pieces up again if there are short-term retracements. Reduced risk, with whipsaws along the way actually adding to the final profit.
Paul H
Opinions appear divided over the use of trailing stops. Rather than as a means to lock in profits, they can be used to reduce losses. If you start with a 1:1 risk reward, moving the trailing stop as price moves up will reduce losses if price suddenly reverses. The overall risk reward over a number of trades is then better than 1:1 giving a slight edge.
Philip
Sound advice, though trailing stops a bit iffy, I’ve come across a strategy recently that could use a trailing stop as it moves to breakeven at 1:1 and takes full profits at 2:1, outside of that I can’t see a rationale for trailing stops. Actually i wonder what an account would compare like if that would be done on trades as a rule where targets are 2:1??? mmm.
Philip
To add to that, breakeven is acheived by taking 50% at 1:1 normally and leaving the stop due to pullbacks, esp on breakouts, but I think such things are best left to the weekends to look at…
Guy
So THATs why I keep losing money on my trailing stops!