Taking Profits and Setting Exits

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 stop before you enter a position based off of your money management rules such as position sizing and expectancy. If you have a $25,000 account and want to risk 2% of the account on a $50 stock with an 8% stop; we know that the trade will allow you to buy 125 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%? Where should the stop be placed at that point to eliminate the chance of losing that quick 20% gain?

Several books attempt to explain how to take profits and many traders of the past have offered advice in books but most of it is fluff and subjective to opinion. I have heard people 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? I thought so several years ago but have developed a more mechanical system that gives me precise exits at any time during an up-trend. It is a combination of a trailing stop and a retracement stop based upon the actual gain at any point in time. In a bull market, I will allow the system to loosen itself so I can handle a healthy pull-back without selling before a possible large move. For now, let me focus on my method for locking in profits without giving back too much.

For the sake of this article, I will continue to use the trade suggested above as the round numbers should be easy to follow.
Account Size: $25,000
Risk: 2%
Stop Loss: 8%
Share Price: $50

Shares to Purchase: 125 or $6,250
Sell Stop: $46.00
Worst case loss: $500 or 2%

If you are unsure how I came up with the numbers in this example, please go back and read these blog articles first:
Position Sizing - Why Losing Isn't Everything

Position Sizing Examples (simplified)

We buy the stock and it is up over 20% after the first three weeks 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.

Please understand that I use these numbers since I like the separation of advances to be at least 10% from one retracement stop level to the next. Any investor or trader can substitute the numbers with something that makes 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). Other times, I have a specific price objective when placing the trade and will close the position if the objective is reached (even if the trend is still higher). A great example of this are the options I purchased in Tenaris (TS); I sold at $45 per call contact, yet they are now trading at $80 per contract. I bought above $10 per contract and had an objective to sell when the stock reached $145 which it did, so I sold my calls and moved on. Looking back, I got out much too early but didn’t violate any of my rules which is more important than the additional gains. If I violated them on this trade and it worked out; what would stop me from violating them in the future and getting slammed with a heavy loss. I hope you get the point.

As I said last night, I am going to upload a simple excel spreadsheet that will allow you to play with position sizing setups and the type of stop that is described above. The stops are integrated into the spreadsheet to show you where to take profits and can be tweaked to your own parameters within your own system. Once I decide where to host the spreadsheet, I will post a link that will allow you to download it.

I will follow-up this article with anther in-depth article that uses a real time trade that I currently have in my portfolio to show you where I will close the position if the price drops. I hope to have the spreadsheet uploaded by that time so you can plug in the numbers to understand on a deeper level.

Piranha