Chapter 15. Taking Gains

“So tell me, when do I sell?”

Do you expect gains or are you surprised by them? I’ll never forget one of my first successful trades under the tutelage of Rev Shark. I had stalked a pattern for several days while the stock methodically set up to my liking. Although I don’t recall the company, I can still see the bullish pennant in my mind as the chart wound tighter and tighter below its descending trend line and above its ascending trend line, creating a pennant (as the name suggests). The pattern projected the possibility that a rather large break was coming. Because I sat in front of my computer day in and day out, I did not feel the need to enter in anticipation of the break. Instead, I waited for the break to occur and resolved to react when it happened. Since I was reacting to a trend break, I made a mental note that if and when the break came, my stop would be a failure of the same break I was buying.

Finally, after days of observation I watched the stock start to break above the descending trend line I had drawn from the recent peak. Volume was high, and I didn’t hesitate to pounce when the time was right. The stock broke out above the trend line and caught significant momentum. The gain for that day was larger than I had experienced in any short-term trade I had ever taken. To say I was excited was an understatement, and I wasn’t shy in relaying my enthusiasm to my then trading mentor. I couldn’t wait for the accolades I was sure to receive. I was certain he would pat me on the back and give me a quick high five, fanning my growing confidence flame. I’ll never forget when he looked right at me and told me to sit down and relax. It was a harsh tone, as if I had done something wrong, and I felt a sense of shock and disbelief. I was angry that my excitement was just zapped with a few quick words. However, I was anxious to hear what he had to say next. Without missing a beat, Rev sternly looked my way and with as cold a face as I had ever seen said simply, “Expect gains; do not be surprised by them.”

Those words have rung in my ears since. This one comment sparked the honest realization that I viewed trading as a gamble rather than a controlled vehicle for consistent profits. At the core, I believed successful trading had more to do with luck than skill. It was a harsh realization of just how much I needed to grow.

I am going to assume that you may possess the same mindset as I did, and not truly expect gains. When gains come, you are as surprised by them as I was, and if you are honest with yourself you might admit that accepting losses is actually easier than accepting gains, simply because it is much more familiar.

The goal of what you are learning here is first and foremost to develop a solid strategy, giving you a defined edge from which to consistently profit. However, it is just as important to remove those profits from the market so that your equity curve is steadily on the rise. What good is it to trade successfully and not withdraw those profits from the market to build your own account?

If there is one area of trading that is rarely, if ever, discussed, it is the strategy of taking profits. I find it interesting that hundreds of books are written on how to trade stocks, which subsequently attract millions of readers seeking to do just that, with little or no discussion about what to do next. It seems to me more traders are interested in finding the next great stock than they are in producing incremental and consistent gains.

You may also make the assumption that once a profit occurs you know what to do when your strategy actually works. I can personally attest to the fact that even when I finally had a firm grasp on pattern recognition and a solid understanding of when and where to enter trades, I still knew nothing about appropriate trade management and how to realize my gains. It was if I had acquired all the variables needed to make money but had no strategy whatsoever on how to keep it. This lack of understanding resulted in a very chaotic and erratic equity curve. I would go on large runs, as profits seemed to flow easily into my account, but would then experience incredible drawdowns taking me back to where I started or even below. I had learned to make money and expect gains, but my actual equity growth was far from consistent and always relied on my general feel for when to get out of my positions and raise cash.

At times, this feel worked just fine for me. However, when I annually reviewed my trading sheets and journals, I realized that I was often selling far too early, or at times, far too late. Although my general feel was better than that of most investors, it was far from consistent. What I needed was a system for managing my trades that removed my “feel” from the equation altogether. At the urging of a dear trading friend, I adopted a systematic way to take gains that built on my existing strategy of individual trade risk. I decided to start taking profits at levels that were a multiple of my initial risk per trade. This system was yet another piece of the puzzle to round out a solid trading strategy that now produces consistent returns, regardless of the market direction.

My profit-taking system is rather simple, in that gains are taken at one and two times my initial risk level for the trade. At each level, I sell or cover a third of my initial position. Unlike when I set stops, these profit targets are based solely on multiples of risk and are not a technical view of where a particular stock could go. While I have experimented with many profit-taking strategies, the calculated method described is unemotional and consistent. Once a profit target is realized, I adjust my stop on remaining shares to ensure my now profitable trade does not turn into a losing trade. When the stock moves past twice my initial risk level, thereby leaving me with one-third of my original share count, I keep the remaining shares with the possibility of a larger move evolving over time. While my profit-taking system is not designed to hold large positions through substantial moves, it is effective in booking continuous profits within successful trades. Although you will never hit the proverbial homerun, the multitude of singles and doubles will result in what should become a continuously rising equity curve.

Let’s look at an example. Your trade-management system, if you use my approach, begins first and foremost with your individual risk per trade. For the purpose of this example, let’s assume that you are adhering to a $300 risk per trade. You are considering a long position in stock XYZ, which is selling for $12 per share. You note that the trade would no longer be valid if the stock drops to $11 per share. So you place your stop at this level. Taking the difference between the entry price and your stop price, you calculate that you can buy 300 shares, risking $1 per share and, thus, your $300 risk limit. Shortly after you enter the trade, the stock begins to rise and in a matter of a few days achieves your first profit target of $13 or your initial risk ($1) added to your initial purchase price ($12). It is at this point where you sell one-third of your shares, or 100 shares, locking in an initial profit of $100, less transaction costs. After selling one-third of your position, you then raise your stop from the original $11 per share to your entry point of $12 per share, ensuring you do not allow a winning trade to turn into a losing trade. In this particular example, we’ll assume your stock continues to rise and in a matter of days trades at your second profit target of $14, or twice your original risk. As with your first sale, you again sell another 100 shares, or one-third of your position at your second profit level, locking in another $200, less transaction costs. At this time, you raise your stop from your previously raised $12 to your first profit target of $13. In the event the trade reverses at this point and stops you out, you at least secure another $100 on your final 100 shares, again not allowing your trade to turn from a winner into a loser. Now that you have achieved your second profit level, it is at this point where the trade-management strategy allows for the final one-third position to move freely. Should the stock continue to advance, you will participate in the move with your final 100 shares. In the event the advance comes to an end, resulting in a reversal and a decline, your final 100 shares should stop out at your second profit target of $14, resulting in another $200 gain.

You can customize your profit strategy however you like, and there may be a multitude of methods from which you can pursue a similar strategy. I strongly encourage all strategies to include two basic principals: booking partial gains as the stock is becoming profitable and raising stops to ensure profits do not become losses.

You may have already started to wonder why I don’t recommend pyramiding into a position, whereby you actually add more exposure when the trade is working. Or why I don’t recommend the general rule that you should let winners run and cut your losers quickly. Interestingly enough, I have explored and utilized both strategies and found that personal emotions became too big a factor when it came to trade management. What this meant was that my emotions were controlling my trading, which could be influenced by a wide range of variables, including anything from my general feel of the market to how I was physically feeling that day. With no set strategy, I had no guidelines to follow to help me to know when to sell and take gains.

At first, I resisted the thought of a system that booked gains as soon as a stock showed a profit. This negative feeling was trumped by my desire to maintain an increasingly rising equity curve. After using this trade-management system for several years now, it will remain with me forever. There is something invigorating about seeing a continuous flow of profits into my account. Even when stops are taken on winning trades, they are done so in correlation with profits and so as not to let winners turn into losers.

The system works for short positions in the same manner as longs, such as our previous example. Let’s review a trade I had while writing this book (see Figure 15.1). In January 2010, I had been drawn to a potential short in Albemarle because the stock had been flirting with a breakdown of an angular ascending trend going back to early March. My first attempt to short Albemarle was on January 27, and was stopped out just a few days later. I continued to watch the name for a potential setup to transpire from which I could reenter the short. I got my chance on February 4, when the stock once again pushed through the trend line looking as though it would have some follow through to the downside.

Figure 15.1 Albemarle Corp breaking below an ascending angular trend.

Chart courtesy of Worden–www.Worden.com.

Although I actually took this trade within my fund, for the purpose of this example I’ll use a different risk calculation, using the same price per share that was actually executed: assuming my risk was $1,000 for the trade, and entering the short trade at $35.91 with a stop over the day high of $36.50. As a side note, I chose my stop over the day high because I felt that if this stock were to reverse over this level I would no longer want to be in the trade because the move would negate the trend break. The difference between my entry point of $35.91 and my stop $36.50 was .59. This meant I was able to sell short 3,389 shares to keep my risk for the trade at my $1,000 limit. I immediately calculated my first profit level so that I could place a limit order to cover one-third of my shares at this level in the event I was away from my desk or the stock moved too quickly for me to actually enter the order.

With a risk of .59 per share, this put my first profit target at $35.32. I achieved this level the next day as the stock continued its decline. At this level, I covered one-third of my position, or 1,130 shares, locking in a profit of $667 dollars. Immediately, I lowered the stop on my remaining shares to my entry price of $35.91. I also set a new limit order to cover another one-third of the shares at my second profit target of $34.73. It just so happened that on this particular day the sell-off was rather vicious, and I achieved my second profit target just a few hours later. I covered another 1,130 shares, locking in an additional profit of $1,333.40. My realized gain thus far on the trade was slightly over $2,000. Once my second profit target was achieved, I raised the stop on my remaining one-third to my first profit target of $35.32 and let the final shares move accordingly.

When using a risk-multiple profit-taking strategy, you might review a pattern you find favorable and note how the technical action may be suggesting the stock’s next move. In such a case, your first concern is to consider the point at which you would be wrong, thereby determining your stop. You should also consider the general potential for profit based on the risk multiple. As a general rule of thumb, I do not advise entering into a trade that does not look as if three times your initial risk is possible. Although you might not know this for certain, you can gain a general feel just by reviewing congestion areas that fall above or below the point at which you would be taking the trade.

For example, suppose you find a stock worthy of shorting. The stock has been consolidating in a fairly narrow range, indicating a breakdown may be forthcoming. The stock is trading at $25 per share, and you note that a breakdown level would be approximately $24.50. In addition to the breakdown level, you note that a reversal back up to $26 would negate the trade, and thus give you a total risk per share of $1.50 if the trade triggered ($26 – $24.50). As you review the pattern, you note that several months ago the stock was trading lower and spent a considerable amount of time around $20. Based on your read of the chart, it is clear that this level would provide a significant amount of support. While not guaranteed, you assume that if the stock were to break your level of $24.50, the stock would at least pause around $20. Because your risk per share is $1.50, three times this risk would be $4.50. Because your trade would trigger at $24.50, achieving a multiple of three times your risk would place the stock at $20, the area in which you see significant support. From your vantage point, this trade is presenting you with at least three times your initial risk and is worthy of your capital.

Let’s assume that rather than $20 you noted that the longer-term support was at $22. As a logical area for where the stock may stop declining, this presents you with a potential reward of slightly below two times your initial risk. This would no longer be as favorable a risk profile as the previous example and is not worthy of your trading dollars. As you become more familiar with chart patterns and logical areas of support and resistance, calculating the approximate risk profile for a given trade will become easier. There was a time in my trading when I would swing for the proverbial fences, seeking outsized returns by taking outsized risk. The results were erratic and at times yielded great returns, but rarely allowed for sustained progress. Regardless of how great the success, it seemed I always went through extreme periods of heavy drawdowns. This emotional roller coaster led me to develop a trading system that seeks much more consistent and sustainable returns. Over time, this resulted in a steadily rising equity curve, correlating with a much more balanced and unemotional approach to trading.

No matter how long you trade or how successful you become, you will still face challenges. I now find myself struggling to keep my final third piece after my trade has already reached my first and second profit targets. The allure of booking the entire gain becomes too great, and I find myself closing out the position time and again. It is a good problem to have, but one that I am personally trying to improve. No matter how successful you become, you can always find areas to improve on. This is one of the exciting challenges presented through the world of trading stocks. Embrace this challenge and meet each obstacle head on. Not only will you improve as a result, your equity curve will also nicely reflect this progression.