Which is better: taking profit or letting it ride?
Many traders say it’s taking profit. They believe that holding out too long is risky.
And it’s not just retail traders — I know plenty of professionals who agree. It seems that few people can resist the urge to cash in a winning trade.
Last week, I told you about the Pareto Principle, otherwise known as the 80:20 rule. The principle states that 20% of your activities produce 80% of the results.
Here’s an example from everyday life…
Imagine you write a to-do list with 10 jobs. A couple of those items will probably deliver a much bigger payoff than the rest. These are the tasks that you should focus on first.
Grasping this idea could help you achieve more than most people. The key is to direct your energy into the 20% of areas that produce the greatest benefit.
Now, this raises an interesting dilemma for traders: If you take profit on your top 20% of trades, are you capping the stocks that could make you a lot more money?
I’m going to answer this question in a moment. You’ll see how a $50,000 portfolio performs under two scenarios: taking profits and letting winners run.
But first, here’s a review of last week…
A quick recap
The inspiration for the past two updates is a member’s email.
Here’s an excerpt of what he said:
‘If part of your thinking is that, on each entry, the potential profit/loss ratio should be 3:1, it follows that if the initial Stop Loss is 25% below the entry price, then the target should be 75% above that entry price.
‘There are currently 173 stocks in the portfolio. Of these, only 8 are now sitting on a profit of more than 75%. Clearly, these have the potential to make a very large profit.
‘With hindsight, however, is it not true to say that the probability of picking one of these signals to invest in would have been less than one in twenty (or 4.62%)?
‘What I’m wondering is, what would happen to the overall result if the system took the profit at 75% on the rare occasions that the target is achieved?’
Les raises two interesting points:
- Relatively few stocks are ahead by more than 75%, and
- Would a take profit strategy boost performance ?
I discussed the first point last week. You can read that update in full here.
But in short, Les is correct — only one in 15 of Quant Trader’s signals are up by over 75%.
Here are the current stats…
There are 166 open long trades in the portfolio (as of COB on 16 April). Of these, the top 20% of stocks are showing an average gain of 82%, while the next 80% net-out near breakeven.
You’ll recall this graph from last week:
The graph ranks Quant Trader’s open long trades from best to worst. I’ve excluded the top four trades (411%, 330%, 258% and 135%) to enhance the graph’s scale.
You’ll see a shaded area on the left of the chart. This contains the top 20% of open trades. As per the Pareto Principal, these positions make up a big share of the gains.
Les notes the relatively low odds of buying one of the top stocks.
And he’s right.
That’s why I say spreading your capital is so important — it increases your chances of buying the best performers. The strategy is about many relatively small trades, not a few big ones.
Remember, it may only take one big win for your portfolio to beat the market.
This leads to Les’ second point: Would a take profit strategy boost performance?
Let’s look at that now.
Fold or hold?
Les asks about the merit of selling if a trade is up by 75%. His logic is that it’s better to lock in a large profit than risk having a stock fall back.
This intuitively makes sense to many people. Cashing in a big win seems like a sensible approach. It’s probably why profit taking strategies are so popular.
But does selling before a trend finishes maximise your results?
Well, I put it to the test during the week.
Here’s what I did…
I back-tested two variations of Quant Trader — one with the regular exit method that lets profits run, the other with a profit taking trigger if a trade’s gains reach 75%.
To make the simulation more like a regular portfolio, I set the starting capital at $50,000. The strategy invests 4% of capital in each trade. This allows for a 25-stock portfolio.
As always, there’s no allowance for costs or dividends.
What do you think will happen?
OK, check this out:
There’s a high correlation between the strategies. But the blue line is gradually pulling away.
Are you able to identify which one this is?
Well, it’s the one that lets profits run.
Now this doesn’t mean it’s wrong to take profits. Selling a stock after a large gain could lower a portfolio’s volatility. Reducing risk may also make it easier to sleep at night.
And that’s not all…
Profit taking strategies can do better in some conditions. Take the first six months of 2017 for instance. The graph shows the orange line is rising faster than the blue line.
But I believe letting winners run is the most profitable strategy overall.
Just consider the back-testing period for instance. The average return on the top 5% of trades was 191% — these are the stocks with the biggest impact on returns.
As the principle says: A small portion of inputs creates the greatest output.
There’s no doubt in my mind…
Profit taking strategies cap your portfolio’s potential. To maximise profits, you must let your ‘Pareto’ stocks run. These are the trades that could double, triple, or more.
Until next week,
Editor, Quant Trader
Editor’s note: Making money in the stock market is hard. Your job will be even tougher if you’re regularly selling your best stocks. People who do this rarely get big triple-digit gains.
But it doesn’t have to be this way…
Quant Trader uses a unique strategy to keeping you in winning trades longer. The aim is to give you the confidence and knowhow to get the most from your trades. Some of the strategy’s wins include: The A2 Milk Company Ltd [ASX:A2M] +320%, Vita Group Ltd [ASX:VTG] +199%, HUB24 Ltd [ASX:HUB] +147%, and Blackmores Ltd [ASX:BKL] +353%.
All graphics produced by Quant Trader unless otherwise noted.