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TradingMarkets.com
Three Ways To Lock In Profits
Monday September 8, 10:24 am ET
By Larry Connors


It's Official: After One Day Of Practice, I'm Not Yet An Idiot!

Well, I survived the weekend of player assessments for my daughter's softball league and then on Labor Day, I got the chance to draft my team. For those of you who have managed a team before, you know that drafting the kids is obviously important. But there's one thing even more important: Drafting the parents! I want to win as bad as anybody, but I sure as hell don't want to deal with too many mothers and fathers who believe I'm the only thing blocking the path to their daughter becoming the Barry Bonds of Little League softball. So my strategy was three-fold: draft the two girls who are among the best pitchers in the league; get nothing but hitters (fielding can be taught quickly, plus if my pitchers do their job, it's minimal-event); and most importantly, CHOOSE THE KIDS WHOSE PARENTS ARE NOT PAINS IN THE ASS!

Now, you may think that drafting such a team is impossible, but son of a gun, I may have pulled it off! Our first practice was Thursday evening (the temperature at practice time was a slightly warm 102 degrees) and for two fast-moving hours, I saw pitchers who can pitch, kids who can hit bombs (and most don't even pivot correctly, so in no time they'll be hitting even harder) and lastly, no parent came up to me during or after practice to tell me that I was an "idiot". Now, you may think I'm excited about the first two things (which I am) but honestly, the third one gets me the most excited. And now, I'm shooting to get my name in the record books. According to Major League Baseball, Cal Ripken played 2,632 games in a row, over 16 years to break Lou Gehrig's record. And, according to Little League statistics, the record for any manager not being thought of as an idiot by their players' parents is a just a bit shorter...two weeks. Ripken obviously had an easier target to shoot for in his quest but what the heck, I'm going to give this Little League record a try. Records are made to be broken and my mission has begun. I'll keep you abreast of my progress as it unfolds.

Locking 'Em In Versus Letting 'Em Run

As I've mentioned many times before, it is critical to have risk control measures in place. Unless you are using proper stops and correct position size, you will likely not last very long at this game. But, let's assume you have a protective stop strategy that you apply consistently, and you are taking positions that assume proper intra-day and overnight risk parameters. With that assumption, let's then assume a stock moves in your favor and focus this week's lessons on when and how to take profits.

Three Guidelines For Taking Profits

First, if you're expecting some magical formula as to how to sell at every high and cover your shorts at every low, you'll not find it here. It doesn't exist (though I'll probably spend at least another 20 years of my life looking for it). Trading is a game that always changes and there is no way of knowing ahead of time if the stock you just sold won't rise 200% over the next few months. And on the opposite end of the spectrum, how many times have you watched a stock -- which you had a healthy profit in -- move lower instead of continuing its rise? These are common situations that play themselves out thousands of times a day, every day in the real world of trading. But, there are some general rules you can follow that hopefully will make you better at capturing gains when they exist. Here are some things for you to think about and next weekend I plan on looking at specific trades in order to dive deeper into this subject:

1. You Need To Lock Pieces In

This means taking profits along the way. And the more aggressive you are here the better. In my opinion, many traders leave more money on the table because they are looking for home-runs. You, nor anyone else in the world knows ahead of time if a trade is going to rise 10 cents or 10 points. Accept this fact and you will immediately learn the importance of scaling out of a trade. This can be done many many ways. Fixed points, support and resistance, fib zones, etc., but lock 'em in.

For example, you're long 2000 shares of Mercury Interactive (NasdaqNMMERQNews). Let's assume you're a short-term trader. You buy at 49 and your stop is at 47.50. When risk equals reward (meaning 50.50), you should be taking a piece off. What's a piece? Your call, but 20-25% of the position may not be bad. You then raise your stop to break-even on the remaining shares, and unless something crazy happens overnight you now have a profitable trade. Now let's assume the stock continues to rise. As it's moving higher, you keep taking small pieces off and aggressively raising your stop. If the stock pulls back and hits your stop, you take your profits and move on. Yes, you will hate life if they find you and then the stock explodes higher. But guess what? It happens to EVERY successful trader. You just need to accept this. If your stop is not hit and the stock continues to move higher, you have some profits locked in plus the opportunity to participate in further gains on your remaining piece.

This is not rocket science stuff. It is simply buying wholesale and selling retail. Trading desks call this "moving inventory" and that's why so many of them are so successful. I suspect most don't go home at night second-guessing themselves on every trade that went higher after they sold. It's not their job. Their job is to take stock in cheaply and piece it out at higher prices. So is yours.

Know Your Time Frame

If you are an intermediate-term trader, you should be looking to make many points on your trades. If you swing trade, the goal is a few points (on average). If you day trade, it's usually in the 20 cent-$1.00 range. This is standard. Yet, many traders grab profits on their entire position much too soon!

For example, many traders like to refer to themselves as swing traders. That is, until they have a gain of 50 cents which then drops to 30 cents. Instead of standing pat and waiting the potential upside move to work it's way through the many wiggles it will encounter, they panic and exit the entire position. They're just happy to lock in any gain no matter how small it is. Instead of letting the move play itself out, they become "scared money" and exit. This is not a contradiction to number one above. Number one says scale out of positions on a "systematic basis", not a panicky, quick trigger basis.

Doing this correctly requires you to know what the average successful move will likely be. And most times, this average move will be dictated by the amount of time you stay in a trade. If it's a few days, which means you are looking for a few points, you don't bail out of everything because you are up a few cents. If the holding period is longer and the potential gains are higher, you need to allow more room and time for the gains to occur. Taking 30 cents while risking 1-1 1/2 points is not the path to riches. It's the path to losing for sure.

3. Get Aggressive at Extremes

This means that the more overbought the market becomes, the more aggressive you should be in locking in long gains. And the more oversold the market becomes, the more aggressive you become in locking in short gains. We have done numerous studies on this and they all point to the same thing. The more OB/OS the market becomes, the closer and more likely the market is to reversing. It's next to impossible to know if this is the 3 or 4 times a year that the market is going to go on a tear, but I'd rather have locked in gains and missed a few big moves than to lose profits time after time because the market reversed. This one concept alone will likely dramatically improve your trading results, especially if you stay disciplined in acknowledging that "the market moves stocks", not vice versa. Next week we'll look at some chart examples in order to gain a further understanding of these three profit-taking strategies.

Have a great week trading (and remember...draft parents)!

Larry Connors