Wanting It All Can Leave You With Nothing

Old sayings can be a great teacher…

They can sum up a situation in just a few words. It’s little wonder they stand the test of time.

You’ll be familiar with the phrase ‘You can’t have your cake and eat it too.’ It creatively describes the concept of trade-offs and the need to make choices between two options.

The saying originated in 1538. Its first use was in a letter to King Henry the VIII’s chief minister.

Variations of the phrase appear in other cultures. The Russian version is ‘You can’t sit on two chairs,’ while the German adaptation is ‘You can’t dance at two weddings.

But the meaning is the same everywhere…

Put simply: You can’t have it both ways.

So, what can a trader learn from this 16th-century saying?

Well, quite a bit…

I’ve been telling you about a selling strategy for the past two weeks. The secret to making big profits is to resist the urge to take small profits. You need to let your winners run.

Many people understand this in principle. But they struggle to put it into practice.

A problem I often see is traders being too protective of profits. Yes, they want to let their winning trades run. But they don’t want to give back any profit…they want to have it both ways.

This update is the final instalment in the series. I’m going to show you the result of holding on to profits too tightly. You’ll see why overprotective traders rarely ride big trends.

A protective flaw

OK, let’s get into it.

Have a look at this chart…

Source: Quant Trader

Click to open new window

You’ll remember this graph from last week. The company is mobile-phone reseller Vita Group Ltd [ASX:VTG]. Quant Trader gave three signals to buy this stock.

Now, have a close look at the trailing stop (it’s the red line that resembles a staircase). This is the trade’s exit point. You’ll notice there’s often a wide margin between this and the share price.

People sometimes ask why Quant Trader risks giving back so much. They’ll point out that the exit level is often around 25% (or more) below the share price. This is too much, they say.

The typical suggestion I hear is to set the exit point closer. This would allow a winning trade to run, while protecting more of the profit — a classic case of having your cake and eating it too.

This sounds reasonable, but there’s a flaw.

Setting the trailing stop too close creates a new problem. It typically results in a stock hitting its exit point sooner. This can get you out of a trade unnecessarily.

You see, just about every trend zigs and zags its way to the top. This means you need to give a stock room to move. Bringing your stop in too close increases the odds of an early exit.

Let me show you what I mean…

Source: Quant Trader

Click to open new window

You’re looking at another chart for Vita Group. The only difference is the exit strategy.

Look closely at the trailing stop. You’ll see that it tracks a lot closer to the share price. I’ve set the algorithm to sell when shares fall by 10% from the latest high.

Many people use a stop like 10%. They give a stock a little bit of breathing space, but quickly close out the trade if the shares slide for a few days. This makes it much harder to ride a big trend.

Compare the charts for the two strategies…

Quant Trader’s three entries produce gains of 199%, 169% and 117%.

The close stop strategy results in 12 trades (not all shown) averaging -1.2%. That’s right, minus 1.2%. Being overly protective of profits could have lost you money, despite a terrific trend.

Now, let me say this: Close exit stops won’t always end with losses. But they can make it difficult to stay with a large price trend. The example above shows just how hard that can be.

Strategy matchup

OK, I have one more chart for you. You’ve seen the difference a close stop can make to an individual stock. Now let me show you how it can affect a portfolio…

Source: Quant Trader

Click to open new window

This graph shows the hypothetical profits from two exit strategies. It pits Quant Trader’s wider stops (blue line) against the strategy that exits after a 10% fall. The back-test is over a 16-year period.

The most profitable strategy — by far — is to give stocks room to move. Attempting to protect profits too tightly produces inferior results.

But that’s not all.

Let me also show you what’s happening behind the scenes…

Tighter exit stops don’t stack up if you want to trade big trends. They typically lead to smaller average gains (and losses). And a significantly lower dollars won/dollars lost ratio.

But the standout figure is the number of trades.

Setting your exit stops too close can dramatically increase turnover. This not only impacts management time, but adds to emotional and financial costs.

Tighter stops are more suitable for shorter-term strategies. I also believe it helps if you’re a professional trader. Active share trading can require a fulltime commitment.

Quant Trader doesn’t chase quick profits. The strategy targets medium-term trends — like the one you saw in Vita Group. And these typically need more room to move.

Every trader has an option…

  1. Use close stops to trade short-term trends; or
  2. Target medium-term moves with wider stops.

But you must choose. The reality of trading is that you can’t have it both ways.

There’s a reason so few people stay on large trends. It’s because they try to hang on to every dollar of profit. They want the big win…but they don’t want to risk giving anything back.

As the saying goes: You can’t have your cake and eat it too. A wide trailing stop is the price you pay to ride a medium-term trend. That’s how you get the stocks that double and treble, or more.

Until next week,

Jason McIntosh
Editor, Quant Trader

Editor’s Note: Does your exit strategy keep you on the big trends? I mean, the trends that go on for months, and take a share price more than 100% higher.

Don’t worry if the answer is no. You’re not the only one. Many people miss out on the full potential of the big trends. But here’s something that could help…

Quant Trader uses a trailing stop to manage selling. This is an exit level that follows a share price higher. The aim is to ride the uptrend to maximise your profits. This is how the system captures gains like 353% in Blackmores [ASX:BKL], 199% in Vita Group [ASX:VTG], and 147% in HUB24 [ASX:HUB].

So, if you’re not sure when to sell…I strongly suggest you check out Quant Trader .

Try it. See if it makes sense to you. It could change the way you trade forever.

From the Port Phillip Publishing Library

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