A legitimate question asked by the newbie is, should you use profit targets or trailing stops when exiting a trade? In this post, I'll give my unashamedly biased opinion in favour of trailing stops and why that is.
I'm no fan of the 'profit target' but not without good reason.
Let me explain why I think they're far from optimal, and show you how my own simple stop-loss method is one of the keys to my short-term trading profits.
Cutting profits short and letting losers run
When I first started out trading I was fortunate enough to read the Market Wizards series of books, and the holy bible of trading itself, Reminiscences of a Stock Operator.
I fully embraced the wisdom of both.
Especially cutting losses and letting profits run - though, I often found it hard to do.
When we're beginning we have a tendency to do the opposite of what we should.
We can't help letting losses get out of hand, and taking the tiniest of profit.
We know the theory, but applying it is another story.
There are all sorts of reasons for this.
Pick up any book on behavioural finance and you'll read a ton of them. They're probably right.
But, sometimes there's an easy explanation.
We just don't believe what we're doing actually works.
Belief in what you're doing
We probably came to the trading with all these preconceived notions about what it was all about.
Thinking stuff like complex math, lots of news reading and convoluted economic theory were somehow key to success.
So we find it hard to believe by following a few price patterns we can make money. Often we do a double-take seeing a position become profitable.
Add a chronic lack of abundance mindset is it any wonder we close out positions too soon for small reward?
The senseless of profit targets
Ringing the cash register too soon is a novice mistake, one eventually grown out of.
But as traders gain experience some fall under the illusion of the profit target, which I admit does have the air of professionalism about it.
We incorporate them into systems, spouting phrases like ' I always take profits at X:risk'.
There are heaps of ‘gurus’ promoting the profit target approach. So it's understandable why beginners fall for it.
Many of the gurus even suggest taking profits at 2:1 or lower!
Call me stupid but I just can't see the logic.
Taking a predetermined profit might feel good for all of about five minutes, until the market zooms right past your exit price and you're scared you've missed a much larger move.
I’ve had 4Rs, 6Rs and 10Rs. So it puzzles me why anyone would want to limit their profit so much.
I view the profit target as nothing more than a fear of trading, cloaked in veer of respectability.
That might seem harsh, but the cold hard math doesn't work out in favour taking profits too soon.
The reasons why you set profit targets
- the market has got form when it comes to reversing on you
- you're on losing streak and no matter how small the profit, it's good for self-esteem
- the need to be a hero and call the exact top of the market
- your trading ability is so shoddy you use a protective stop-loss measured in hundreds of pips
- the trade was entered at the most obvious breakout level, and you've missed half of the move already
- you fear for your position at every conceivable support or resistance
None of the above I'd ever consider good trading habits. So if you're still using profit targets, maybe it's time to ask yourself why?
The dangers of anchoring
Anchoring is really just a posh way to say setting a profit target.
I'll tell you about one of my more memorable episodes with anchoring.
Back in 2010, I'd rode the price of silver up from around $19 into the high $40s.
I was going to cash out at $50 with huge winnings.
In the space of 8 months, I'd quadrupled my account (oh the wonders of leverage) and was full of myself.
The height of my hubris being to taking on accounts from family and close friends.
To cut a long story short, silver never did reach $50. It reached $49.87 and then started selling off big. I was stopped out but still up big.
But I just couldn't shake the $50 target from my head.
I started looking at intraday charts, trying to find a suitable re-entry.
I kept opening new trades and kept getting stopped out. After a few losses in a row, I said, to the hell with it and just held a core position as silver declined $15 in four days.
Needless to say, I held all the way down, but it wasn't just my account I was concerned about, it was other peoples too including that of my dear mums.
I think I finally gave it up about $20. But then I didn't really care, I'd given up all the profit for the year and just wanted out of the pain.
The word, distraught, comes to mind. It took me a year to fully recover from that episode.
But, I never did anchor a price target again.
Trailing stop-loss system
Knowing when to get out of a trade is equally as important as knowing when to get in.
It might sound crazy but there is a lot of stress associated with being in a winning position and not having an exit plan.
You can end up like a deer in headlights, not knowing whether to stay and risk give back profits; or close the trade and risk losing out on more profit.
Having a trailing stop strategy firmly in place removes this confusion.
Broker trading platforms have automated trailing stops, but this isn't what I am referring to.
Automated stops can't move your stop to the last higher low, or last low of the past three days, or the last fractal low below a 10 bar moving average. That might be changing now with AI or advanced computing, I don't know.
But I've always chosen to move stops manually, and sad as it might be, its one of the highlights of my day.
If you're having to move a trailing stop it means your trade is working out.
Tight stops are best for shorter-term trading. You can lock in profits quickly, and if the market turns on a dime (which it often does) you're out quickly without giving back huge chunks of profit.
But, a tight stop isn't good for riding long-term trades. You'll likely be taken out on the first reaction.
If you fancy yourself as a fundamentally driven trader in any way, it's pointless using tight stops. Fundamentals don't take place in the short-term.
If you want to catch medium to longer-term trends try one of these:
- a stop at the last weekly low
- the lowest low of the past three/five days
- a fractal (pivot) low occurring below a major moving average
I've tried them all and they work. But for me personally, wider stops are not conducive to healthy trading psychology.
Markets just don't trend that often. And you end up giving back profits on trades that never make it into the long-term.
Wider stops leave me frustrated, and I suspect many beginners, either are or will be of the same thinking.
Newbies need to see things working out. They need positive reinforcement on a regular basis. This doesn't happen all that much as a long-term trader.,
I wrote a whole post on why short-term trading is best for newbies here.
My short-term trading trailing stop loss method
There's nothing special about the way I exit a trade; other it's so simple I cannot fathom why more don't do the same.
I read all sorts of complex exiting techniques; ATR values, support or resistance, trendlines.
But here is how I do it.
If I am long I trail a stop at the value of the last bar low.
If I am short I trail a stop at the value of the last bar high.
I keep doing it until stopped out.
This is how it worked on two of my past gold trades to give you a better idea.
In trading, it's important to know who you are as a trader. It took me years to figure out who I was.
I'd despair when I'd miss a big move when I defined myself a 'short-term' trader; I'd fret at the thought of missing juicy short-term profits if I defined myself longer-term.
Mine was a constant process of changing style to fit the market environment. Usually, I changed just as the environment changed again.
My quality of life really suffered because I wanted to be all trading styles to all markets. You cannot be like that if you expect to succeed.
In the end, this stop loss system saved me. It gave me the best of both worlds.
With this method, I was able to capture the meat of any larger price moves, but also catch sharp run-ups or downs, which have become my bread and butter.
If you're struggling with the taking profits aspect of trading, then this stop-loss system can maybe help you the way it did me.