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Monitoring a profitable position as it progresses: Remember Rule One? Unless you have some significant profits to offset numerous inevitable losses, you will lose. It’s as important to let profits run as it is to limit losses. Let’s imagine that this trade goes your way. You’re actually in the black. How do you decide when to get out? How much profit is enough? This cannot be left to subjective whim, and should never be based on any news item, no matter how compelling. It’s not new, but here’s the answer: as the position advances, use a trailing stop. Hold on to your position until your stop is hit (1). Notice, this has nothing to do with how much you may have made on the trade so far. It could be 10%; it could be 1000%. It has nothing to do with “targets.” Yes, it’s possible to calculate “fair value,” and if you enter a trade at a substantial discount to fair value, and then exit when it reaches that level, you may actually end up in the black. And it’s possible to arrive at targets based on chart support and resistance levels.

But one thing is certain. If you exit a trade when your target is reached, you will never—I repeat, never—be in any of the huge moves that take place every year. This means you’d better be right often, and not run into any serious down moves while you’re waiting and hoping. As for the constantly rising targets set by the brokerage industry, these are nothing but sales gimmicks. So, from a practical point of view, whether they are arrived at through sane and sober in-depth fundamental or technical analysis, or just figments of the imagination of your typical Wall Street analysts, if you want to capture the maximum profit potential on every trade, there are no valid targets.

Think about it: all initial targets in a good move are exceeded. If you sell when the first one is reached, you’ll limit your profits (a major violation of Rule One), and never be aboard for the best moves. In a good move, analysts repeatedly project successively higher “targets.” But the final target is never reached, and as a result, if you’re planning on getting out when your final new “target” is reached, you are going to be holding till doomsday (the other major violation of Rule One). Although it is possible to know, based on value ratios, that a stock is cheap, which implies higher prices in an up market, or maybe only less damage in a down market, it is not possible to know whether any particular trade will in fact go up at all, or how far it will go, or when this may happen. “There is no air-tight science of stock pricing.”(2) There is not even a rough valid way of determining where the price of a stock should be. The decision to get out must be based on what your position is doing, not where you bought it or where your broker said it’s going. Its future potential can’t possibly depend on where you bought it or on what anyone thinks. Nor can it even be based on whether you’re at a profit or loss in it (assuming that it hasn’t hit your stop yet). This means you might hold it forever, or you might be out in the next few seconds. You may already have made far more on it than you had dreamed possible. If the trade is going your way and has not given you an objective reason to exit, hold on. This is because it has something very good going for it. Winners tend to keep winning! You may have doubled your money on it, and if you get out prematurely, you may leave ten times that on the table. Don’t get out because you’re afraid of losing a good profit. Instead, deal with the fear by raising your stop to lock in some of the paper profit and minimize the amount that you’re willing to give up, and continue to hold. This has the advantage of reducing fear, because you’ve just locked in a chunk of the profit, and guaranteed that you’ll be aboard if the move continues going your way. You’ve limited your downside risk, and still have unlimited potential on the upside. Alternatively, you may believe that there is infinitely more potential in the trade, but it’s just told you (by hitting your stop) to sell. If it has, or if you “forgot” to enter your stop but it has touched the stop price, get out right now! Your stop strategy should be reduced to absolutely objective criteria, and where money management is concerned, the only relevant information is what the price is doing to your money, not what you think it should do. Although it might seem counterintuitive to say this, the precise stop exit method, within reason, is not nearly as important as having some type of stop, without exception. Furthermore, your specific entry and exit rules are less important than the position sizing part of the system above (See Chapter 10). So, assuming that your stop is based on any of the following strategies, you will stand a better change of capturing most of the move. Suggested methods for trailing your stop (there are countless others not mentioned, 100% objective–some fairly technical; if you’d like some of these, let me know and I’ll give you some):

1. Hopefully, you got into your position on a high volume upside breakout from a sideways market. Your breakout point was a chart point, and so it only makes sense to use chart points to exit your position. Starting off, you placed your initial stop just under the most recent correction low. If the move goes your way, a series of upward zig-zags will typically develop. Each one will take days, weeks, or months. Every time the market recovers from one of these pullbacks, and moves to new highs, raise your stop to just under the new most recent correction low. Eventually, the upward stair step pattern will end, a series of downward zig-zags will begin, and you will be stopped out on the first of these. In this way, you will capture all of the move in between. You don’t get in at the bottom, and you don’t get out at the top, but you take a nice slice out of the middle. You’re not tying up your money during the 70-90% of the life of the stock when it’s going nowhere. You’re taking a piece out of it during the period in which it’s moving. And since it really isn’t possible to know the exact top or bottom when they occur, it’s very risky to try to pick tops and bottoms. The piece you take out of the move is the safest piece, because it’s built on a foundation of solid criteria, and begins with high momentum. If you are not extremely familiar with charts, I strongly recommend getting the basics down. Before looking at other alternatives to chart points, it’s fair to point out a few drawbacks to chart points. A) They’re so obvious, that other stops tend to cluster there, so you frequently will get filled a few ticks or worse below your stop; B) sometimes, the final ascent of a stock looks more like a parabolic curve, rising more and more steeply; the nearest meaningful chart point is further and further below. The biggest part of any move typically takes this shape, and since it’s so big, you want to capture as much of it as possible. Since it has risen at a steeper and steeper rate, you have more and more of the last part of your profit at risk, and this will almost certainly put pressure on you to exit prematurely. A common way of resolving a situation like this involves taking partial profits, but a far better way is to stay fully invested, and raise the stop in sync with the market, using a system like the Parabolic, which is in the public domain. I say far better, because to liquidate part of your position means to limit your profits. You don’t get moves like that every day, so if you systematically short-circuit the potential, you’ll end up with mediocre results long term. In the final ascent, the stop will move upwards daily in lockstep beneath the market, and will take you out very near the top when the move ends. [Let me know if you’d like, and I’ll give you the formulas in Excel.] Now, in case all of that sounds too complicated, and you’d prefer something effortless:

2. Each week, advance your stop to just under the 50 day moving average. I mention this because it’s the simplest stop strategy, though not the best. The market will often trade down to the 50, wobble above and below it a bit for a few days, clearing out all of the stops there, then move to new highs. But a stop here is the easiest, because it’s visible on practically all charts, and since it’s effortless, is more likely to be used. So this area will also be cluttered with other traders’ stops, and again, bad fills will happen. Nevertheless, when you compare what you give up on bad fills, with what you could give up if you don’t limit your loss, there really is no contest. So, even if this is the worst possible place to put a stop, it’s better than no stop, and will at least minimally meet the requirements of Rule One. OR

3. Trail your stop a distance of 3 times the Average True Range (3) below the current close. For what it’s worth, Van Tharp found this to be one of the best stop methods researched. The only reason that I don’t personally use it is that I believe I have a method that’s better.

4. If you happen to have a fully automatic statistically based program for determining when the trend has ended (which I do), use this system. [I’ll be happy to give you the formulas in it if you’d like. I’ve converted it into Excel.] The original tests were carried out in Fortran, PL/1, and Basic on a mainframe, on many years of commodity data, and averaged about 100% profits per year, using only 1/3 of equity at any one time. During a brief period years ago, when I had more money to work with, it generated a 70% net gain in 7 months. I also have developed a Position Sizing spreadsheet in Excel that tells you how many shares to buy. Lastly, I periodically transfer all completed trades to another spreadsheet, and then analyze it for information on the criteria that worked best, and for a report card on my adherence to my own rules. This is helping me develop discipline. I’ll go into that further in a subsequent chapter. You will run into many other selling rules, many of them based on fundamentals. For instance, “sell when there are one or two quarters of earnings disappointments.” If you wait that long, your position is typically already in free fall.

Summarizing: You can improve your profitability and minimize your losses through proper position sizing, systematic entering of stops, and by trailing a stop on profitable positions. Assuming you have a tight grip on risk control and profit control, you can improve your score a bit further by choosing stocks that meet certain stringent criteria, which, historically, have outperformed the averages.

Coming up in Chapter 12: Stock Selection Criteria that Work

Notes:

1) I plead guilty to sometimes exiting a stock that is lagging, even though it hasn’t hit its stop, to free up cash so that I can get into another one where the grass seems greener. I’ve observed on a few occasions that the one I was in took off like a rocket shortly after I got out. In 2000, 2001, and 2002 it paid off. But in 2003, I left a small fortune on the table with this strategy. Nevertheless, this practice (which is called the “pig at the trough” approach, because the stronger push out the weaker) is extremely common among successful traders, and is in fact the basis for the ValueLine system, O’Shaughnessy’s 45 year test, Schwab’s successful rating system, IBD’s Daily 100, etc. So on occasion I will still do this, and continue to monitor the overall results. See Schwager, Jack D, Stock Market Wizards, Harper Business, NY, 2001, pp 38,54

2) Shiller, Robert, Irrational Exuberance, Broadway Books, NY, 2000, pp 42-43

3) Tharp, Van K, Trade Your Way to Financial Freedom, McGraw Hill, 1998, p. 328. The ATR (Average True Range) is the average over the last “X” days of the true range, which is the largest of the following: (1) today’s high minus today’s low; (2) today’s high minus yesterday’s close; or (3) today’s low minus yesterday’s close.

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