Topical Thursday #5: Taking Profit
Money don't get everything it's true. What it don't get I can't use. I need money. That's what I want.
It doesn’t matter how accurate your strategy is if you can’t realize your gains. Two of the most common questions I hear are “Should I buy?” and “Should I sell?” and I’ve already talked about the technicals around buying and selling. There are two questions that partner these two questions which are “How much do I buy?” and “How much do I sell?” so now I’ll take some time to talk about the selling part and next week we’ll talk about the buying part. This will be a kinda word-heavy post.
There’s no wrong way to take profits. If you are exiting a position in profit your account at the very least is bigger than it was. Something that affects people the most with taking profits is hindsight. Not hindsight in the present though. Hindsight in the future.
Foresighted hindsight?? Is that a thing? Is there a name for that? Is that the name? Beats me. I know it sounds weird but follow me down this path.
Looking at the present time live charts, when considering taking profits, people think about how they’ll feel in the future about their past actions. They worry themselves over if their future self will say “Ugh I was such an idiot, why didn’t I let that ride back then…” or “Dang, I’m a genius, I’m so glad I got out when I did…”
This type of thinking is unproductive and can be debilitating, but a large counter to this thought process though is that you should never be making decisions based on what you could potentially gain. Risk management should have you thinking about what you could potentially lose and closing out positions in profit to realizing those gains will limit that potential loss. Don’t get hung up on how much you could have made, be glad for what you did and continue to do so and your account will continue to grow.
This consideration should be a part of your trading plan before you even enter into a position.
Profit-taking can be as simple as you like or pretty complex. It can achieve multiple goals but most importantly it’s to remove risk from your position. I’ll cover some of them and why they may be a process to implement.
Building a Small Account or Account Recovery:
A simple strategy to build a small account is to exit positions fully at a risk-adjusted profit level or your stop loss. If you are evaluating your positions with a minimum 1:1 risk to reward ratio and implementing a backtested strategy that wins more than 50 percent you can methodically grow a small account. Ideally, a strategy that can win +50% and has a 1:3 risk-reward ratio should be sought out, but 1:2 can be alright if the win% is on the higher side.
A 1:1 risk-reward ratio means that you are risking a 1 dollar loss for a 1 dollar win. A 1:3 risk-reward ratio means that you are risking a 1 dollar loss for a 3 dollar win. Below you can see how important this ratio is. With statistics of a particular strategy, a sample portfolio can be created to simulate performance with a full exit at your risk-adjusted profit target.
The below slideshow shows the performance of a portfolio after executing 100 randomized trades with a 1:3 risk-reward ratio and a strategy that wins 55% of the time. The trades will close the entire position at a $1000 loss or at a $1300 profit.
The next slideshow shows the performance of a portfolio after executing 100 randomized trades with a 1:1 risk-reward ratio and a strategy that wins 55% of the time. The position will be closed entirely at a $1000 loss or at a $1000 profit.
You can see on average the 1:1 R/R portfolios have a total profit lower than the 1:3 R/R portfolios. Some even ended at a negative value.
Fully exiting positions allows for more executed trades and ensures that ensures stable growth within a particular probablitiy of success. This method can be employed by traders or investers but is more ideal for trading as those time horizons are often much shorter and stop losses are a tricky subject with investments. This method is also more optimal for building accounts and recovering from multiple losses than scaling out strategies.
If you must know how this was created:
Regardless of a strategy’s past statistical performance each future trade is not guaranteed to follow that statistical probablility. To simulate this 100 trades were executed to build the portfolio. Each individual executed trade outcome was selected at random from a pool of 100 coin flips. A 55% profitable strategy would mean a coin was flipped 100 times and 55 flips resulted in heads (winning trade outcome) and 45 flips resulted in tails (losing trade outcome). Trade 1’s outcome is chosen at random from these 100 flips. Trade 2’s outcome is chosen in the same manner, eventually continuing to 100 randomly executed trades that fall under the same potential probablity of performance.
Scaling Out:
Taking profits on the way up instead of on the way down can be much less stressful and emotional. You are operating from a position of confidence instead of desperation. It’s easier to make rational decisions when you are optimistic. Scaling out of positions allows you to lock in gains while riding out the trend and also frees up capital for potential re-entry or purchase of other assets on the rise.
For investors it’s simple but personal. Identify levels of profit that you are comfortable with or identify significant events or identify relevent cycles. Maybe sell off a third of your position for profit at a significant high price resistance. Maybe sell off half of your position when you have doubled your money. Maybe sell off two thirds at the peak of the business cycle. There’s not really a wrong choice. You just have to make one and stick to it.
For traders this works better under certain conditions and isn’t great for small accounts OR if you are coming off of a losing streak. Ideally you have a trading strategy that is consistenly profitable. Ideally you have a particular trade setup that historically produces the same amount of trades per week/month/year/whatever. Ideally you have an account size that your positions size according to risk management will actually net a decent return on a win. The implementation of scaling out for me has been either in halves or in thirds.
If I’m trading in halves, once I’m in a position I’ll exit half of my position at my profit target (or first planned resistance). Next, I’ll adjust my stop loss to my trade’s entry price which will prevent me from losing any money. The second half of the position will be exited with some form of a trailing stop or a breakeven stop loss if price immediately retraces.
If I’m trading in thirds, once I’m in a position I’ll exit the first third of my position at my first profit target. Next, I’ll adjust my stop loss to my trade’s entry price (a breakeven stop loss). The remaining thirds can be exited in one of two ways. I will implement some form of a trailing stop but set a profit target at the next planner resistance. If the planned resistance is reached first I’ll exit the second third of my position and leave the remaining third for the trailing stop. If the trailing stop is triggered first I’ll fully exit the position.
Scaling out is not optimal if you are experiencing a series of multiple losses (it happens to the best of us). At this point you’d need to swap to using an account building exit strategy. The trend following strategy you are using may be becoming innefective because the market structure may be shifting. After a series of losses the account size will return to normal faster with consistent $1 dollar wins than $0.33 wins since the trend isn’t strong enough to hit second or third targets.
I really wanted to nerd out with some more numbers but that’s not what you are all here for. These are simple ways to make sure you are methodically realizing gains and not worried about what you think you’ll think in the future. Also it’s a not so subtle hint that you should probably start considering a trading strategy or methodology to follow instead of just doing stuff willy-nilly. There’s no way to really do anything consistently without a plan or process.
I’ll drop a thread soon with some reading sources to help you figure out what style fits your mentality and thought processes.
I’ve also just figured out I don’t know how to preschedule these posts to send correctly.
See you in the altcoin showcase.
@theprivacysmurf
Loved reading this article, made a lot of sense and removed emotion from the equation. Thank you!
Very helpful! Thanks for the teaching. Looking forward to your list of resources. T