Being Too Protective of Profits Could Leave You with Less
Human nature doesn’t seem to change…
What was true hundreds of years ago is often just as relevant today.
Take this phrase for instance: ‘You can’t have your cake and eat it too.’ In just a few words, it creatively describes the need to choose between two appealing options.
The saying dates back to 1538. It first appears in a letter to Henry VIII’s chief minister.
Variations of the phrase also exist 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: you can’t have it both ways.
So what does a 16th Century saying have to do with trading?
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 ones. You need to let your winners run.
Many people understand this in principle. But they struggle to put it into practice.
You see, a lot of traders are too protective of profits. Yes, they want to let their winners run. But they don’t want to risk giving back any profit. In other words, they want it both ways.
This update is the final instalment in the series. I’m going to show you the result of clinging to gains too tightly. You’ll see why some traders rarely ride the big trends.
OK, so let’s get into this with a chart.
Have a look at this:
You’ll remember this graph from last week. The company is Pinnacle Investment Management Group Ltd [ASX:PNI]. Quant Trader gave three signals to buy the stock.
Now, have a look at the trailing stop (it’s the red line that resembles a staircase). This is the trade’s exit point. You’ll see it’s often well below the share price.
People sometimes ask why Quant Trader risks giving so much back. They’ll point out that the exit level is often 25% (or more) below the share price. This is too much, they say.
The suggestion I often hear is to set the exit point closer. This would still allow a winning trade to run, but protect more of the profit — a classic case of having your cake and eating it too.
Now, you may think this sounds like a good idea. And you wouldn’t be alone. Many of the everyday traders I speak to say they set their exit stops this exact way.
But there’s a problem with this approach. By bringing the trailing stop in closer, a stock will typically hit its exit point sooner. And this could potentially prove costly.
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. Setting a stop too close makes it harder to stay on the trend.
Let me show you what I mean:
You’re looking at another chart for Pinnacle. The only difference is the exit strategy.
Now, look closely at the trailing stop (the red line below the trades). You’ll notice it tracks a lot closer to the share price. The exit triggers when the shares fall by 10% from the latest high.
Many people use a stop like 10%. They give their stocks a bit of breathing space, but quickly close the trade when the price ticks lower. This makes it hard to ride a big trend.
Compare the two strategies…
Quant Trader’s wider exits produce gains of 188%, 148% and 127%.
Whereas the close stop strategy results in four trades averaging 26.1%.
A tight stop strategy may seem like a good idea…it lets profits run and closely protects gains. But as you can see, being too protective of profits could cost you a lot of money.
Wide versus tight
OK, I have one more chart for you.
But first, think about this…
In the previous section, you saw two scenarios: The first used a wide trailing stop, the other set a close stop. As you know, the wider stop gave a better result.
While this is interesting, I don’t draw conclusions from one example. I want to see how a strategy performs over hundreds of trades before deciding its merits.
And thanks to back-testing, this can do done in a matter of minutes — not years.
Here’s what happens when I apply the strategies to a portfolio of stocks:
So which is which?
Well, you’ll probably guess the blue line uses Quant Trader’s wider exits. Allowing trades more room to move produces a better overall result than setting a 10% trailing stop.
And this isn’t just for a select group of stocks…
The back-test covers a 20-year period and includes thousands of individual trades. It leaves little doubt that trying to protect profits too tightly often leads to a worse outcome.
Here’s the data behind the graphs:
Tighter exit stops often don’t stack up if you want to trade big trends. They typically lead to smaller average gains (and losses). And a significantly lower profit margin.
The close exit stop strategy also produces 67% more trades. This not only impacts management time, but adds to both emotional and financial costs.
I think tighter stops are more suitable for shorter-term strategies. I also believe it helps if you’re a professional trader. Active share trading often requires a full-time commitment.
Quant Trader doesn’t chase quick profits. The strategy targets medium-term trends — like the one you saw in Pinnacle. And these typically need more room to move.
I believe a trader has two options…
- Use close stops to trade short-term trends; or
- Target medium-term moves with wider stops.
Traders who try to blend these options often get disappointing results. No matter how they try to finesse it, big trends and tight stops rarely work well together.
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 triple, or more.
Until next week,
Editor, Quant Trader
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