Why bother protecting profits?
How is anyone supposed to answer the question "why bother protecting profits?" The answers are so obvious. And “elementary”, as Holmes would say. Still you would be amazed how often traders allow their profit making positions to turn cancerous.
Au contraire
The market abounds with seemingly contrary adages. Someone exhorts you to “cut your losses and let your profits run” while someone else warns you to “never let a profit turn into a loss.” Someone else wisely advises, “Nobody lost money booking profits.” Leaves a trader quite puzzled about what to do.
It's simple, really. The one way to reconcile these sound but contradictory homilies is through the use of a protective stop loss. How is a stop loss different from a protective stop loss? While a stop loss is used to control your absolute losses in the context of the reward that is expected from the trade, a protective stop loss is used to ensure that the rewards that accrue from a trade are protected.
There are two ways of taking a profit. One is to set a pre-defined profit taking target and exit the position at that level. The biggest drawback of this strategy is that if the trade has more profits to offer than what you have taken with a pre-defined profit target, you would not be in a position to capitalise on it. The only way to make the most of what the market has to offer, the only way to “...let your profits run...” is by using a protective stop loss.
Taken for a ride!
The other drawback of using a pre-defined profit target is that the stock may never make it as far as the profit target at all, despite making lower profits! Most of us lose money on our trades not because we don't see profits, but because we don't know how to protect our winnings. Our favourite analogy to describe the situation is that we get on to the notorious Mumbai local at Vashi with a ticket for Chatrapati Shivaji Terminus (VT to those who don't believe in being politically correct). But unfortunately, the train reverses at Wadala and by the time we get off, the train is at Panvel!
Often trades that start making money will fall short of the reward expectations. If we used only an original un-updated stop loss to protect us, it is very likely that not only will our profits erode but the stock will also move down to change a profit making trade into a loss making one, as we watch helplessly.
While the original stop loss is good enough to make sure we don't lose more money than we intend to, the protective stop loss (which is essentially the original stop loss updated to protect some portion of profits) will make sure we take home at least some of the profits that we have fought so hard to make.
Profits can be so elusive
The protective stop is also the answer to the trader's quintessential dilemma of when to book profits. Get out too early and you may miss the bulk of the move. Don't get out early enough and you may end up giving a large portion of your profits back to the market. (And you thought taking profits would be a relatively painless process!)
So which is the best time to exit a profit making trade? When you have made enough money? (Can someone please explain this elusive concept of "enough money"?) Or is it when your friend who gave you the tip, sells his position? (We would treat that friend like a prince, because that's what he is. Most tip-giving friends usually don't bother to tell you when to sell. Unless it is a week after they have sold, when the stock is trading 20% below its current peak!)
A protective stop loss puts the decision right into the hands of the ultimate arbiter, the market itself. It allows us to let the market decide when we have to exit a profitable position. If the market, in all its benevolence, feels like we deserve more profits than what we wanted in the first place, the protective stop loss makes sure we are there to receive the largesse.
If the market, in all its spitefulness, decides we don't deserve the ambitious profit targets we have set for ourselves, the protective stop loss will allow us to get out with most of the gains we have made. At the very least, it ensures that we don't incur losses that erode our precious trading capital.
Au contraire The market abounds with seemingly contrary adages. Someone exhorts you to “cut your losses and let your profits run” while someone else warns you to “never let a profit turn into a loss.” Someone else wisely advises, “Nobody lost money booking profits.” Leaves a trader quite puzzled about what to do.
It's simple, really. The one way to reconcile these sound but contradictory homilies is through the use of a protective stop loss. How is a stop loss different from a protective stop loss? While a stop loss is used to control your absolute losses in the context of the reward that is expected from the trade, a protective stop loss is used to ensure that the rewards that accrue from a trade are protected.
There are two ways of taking a profit. One is to set a pre-defined profit taking target and exit the position at that level. The biggest drawback of this strategy is that if the trade has more profits to offer than what you have taken with a pre-defined profit target, you would not be in a position to capitalise on it. The only way to make the most of what the market has to offer, the only way to “...let your profits run...” is by using a protective stop loss.
Taken for a ride! The other drawback of using a pre-defined profit target is that the stock may never make it as far as the profit target at all, despite making lower profits! Most of us lose money on our trades not because we don't see profits, but because we don't know how to protect our winnings. Our favourite analogy to describe the situation is that we get on to the notorious Mumbai local at Vashi with a ticket for Chatrapati Shivaji Terminus (VT to those who don't believe in being politically correct). But unfortunately, the train reverses at Wadala and by the time we get off, the train is at Panvel!
Often trades that start making money will fall short of the reward expectations. If we used only an original un-updated stop loss to protect us, it is very likely that not only will our profits erode but the stock will also move down to change a profit making trade into a loss making one, as we watch helplessly.
While the original stop loss is good enough to make sure we don't lose more money than we intend to, the protective stop loss (which is essentially the original stop loss updated to protect some portion of profits) will make sure we take home at least some of the profits that we have fought so hard to make.
Profits can be so elusive The protective stop is also the answer to the trader's quintessential dilemma of when to book profits. Get out too early and you may miss the bulk of the move. Don't get out early enough and you may end up giving a large portion of your profits back to the market. (And you thought taking profits would be a relatively painless process!)
So which is the best time to exit a profit making trade? When you have made enough money? (Can someone please explain this elusive concept of "enough money"?) Or is it when your friend who gave you the tip, sells his position? (We would treat that friend like a prince, because that's what he is. Most tip-giving friends usually don't bother to tell you when to sell. Unless it is a week after they have sold, when the stock is trading 20% below its current peak!)
A protective stop loss puts the decision right into the hands of the ultimate arbiter, the market itself. It allows us to let the market decide when we have to exit a profitable position. If the market, in all its benevolence, feels like we deserve more profits than what we wanted in the first place, the protective stop loss makes sure we are there to receive the largesse. If the market, in all its spitefulness, decides we don't deserve the ambitious profit targets we have set for ourselves, the protective stop loss will allow us to get out with most of the gains we have made. At the very least, it ensures that we don't incur losses that erode our precious trading capital.
If you want to experience all this first hand, pick up Sharekhan’s Day Trader’s HIT List, which captures the trading ranges of all the stocks that are currently the market’s flavour. This product is meant for day trading and all positions need to be squared off by 3.30pm. The list contains 20 liquid stocks.
Trade well!
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