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One of the differences between the successful trader and the unsuccessful one is the ability to book profits at the right time. This is perhaps the least-discussed aspect of trading technique and yet, it is among the most important.
You can pick a stock to trade at random with a roughly 50 per cent chance of success. Even great traders don’t beat those odds by a massive margin and indeed, some of the best trading systems have much lower rates of success in terms of strike rate.
Let’s assume you have taken a trade and your position is in the black. When do you take profits? If you book too early, you fail to maximise. If you book too late, you fail again. Nerves play a big part in this decision. Mis-timing a winning trade and booking profits too early is part of what behavioural scientists call the disposition effect. (So is holding onto losses for too long.)
Some good traders reduce the element of psychology by setting hard and fast rules for profit-booking. Others set hard and fast targets instead. Both methods have pros and cons and they work best in each case with a specific type of trade. The trader should be clear if it’s a trend-following or counter-trend trade.
The trend-following trader cannot set hard and fast targets. You don’t know how long a trend will last if you are following a trend. In this case, setting a hard and fast rule is better. Most trend-following traders use a trailing stop loss. If the trade is in the black, the stop loss is moved up (or down in case of a short). If the trade moves further into profitable territory, the stop loss is progressively moved up. Eventually, the trade will be stopped out when the trend changes and the stop is hit.
In this case, the trader makes successive judgement calls about where to keep the stop loss once he’s making profits. If it’s too close to the price, he gets stopped out on a minor fluctuation. If it’s too far away, he loses the bulk of profits. But when it comes to the actual decision to close the position, all he has to do is obey the pre-set rules.
In a counter-trend trade, the targets are clearly set by the nature of the trade. The trader has identified a range between which the stock moves. He is buying at the low end of the range and selling at the top end. He has a set target when he enters and also a stop loss in case of an adverse breakdown or breakout. Here, it’s just a question of discipline.
The author is a technical and equity analyst