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Profit Taking

Donald L. Jones
Copyright CISCO Futures, May 25, 2004


It is easy to say that the good trader quickly jettisons losers and holds winners until the market changes. But how is it done? A short answer is that the trader needs a strategy and the data to implement the strategy. You can learn about model development at: Trading Model Development. CISCO value data are used in the model development material.

Assume for the moment that you have a strategy. It should provide for entry into a trade as well as the rules for exiting. Entry is the easiest, since that usually comes on a measurable change of value which coincides with a price change (breakout).

Exiting is the hard part. Let us define our exits as "profit taking". Losses can be thought of as negative profits. If we do that, any exit is profit taking. This may seem artificial (a loss is a loss!) but in fact exiting by one's strategy is profit taking (a loss taken now cancels the possibility of it growing, hence you have saved a potential large loss by taking a small one).

Most traders "take profits" by setting stops, many of which have a certain degree of arbitrariness. Value does change as a trend wanes, but it is often a gradual process. When value is no longer changing you have reached a balanced market. Waiting that long to exit puts you into the volatility regime. This is undesirable. Exiting sooner requires market knowledge and a sensitive tracking of market behavior.

There are a number of ways to exit a trade, some are:
1) Placing a stop loss on entry
2) Maintaining a trailing stop, if the position improves
3) Arbitrarily targeting a profit, say $50 or $75
4) Exiting on the close
5) Exiting at a resistance or support point
6) Exiting if the volatility widens or narrows
7) Monitoring congestion with an exit if it grows too large

1. Placing a Stop Loss on Entry
Many trading gurus advise "mental stops". The problem with these is that we too often violate our own rule. We hold and hope. The best bet is to figure out how much you can afford to lose on a trade. Then, where possible, you place the stop when you place the order. That way you are committed. If it is not possible to enter the stop with the order, devise some rock fast method to force yourself to exit at the proper loss level. A stop loss on entry protects you from losing too much if the trade immediately goes against you.

2. Maintaining a Trailing Stop, if the Position Improves
Trailing stops have been around for a long time. They seem so logical. How big should it be? Certainly, it should be reasonable for your trading situation (see Trading Model Development). It must also be larger than the volatility or you can be stopped out by noise: see Volatility and Stops for the DayTrader Any stop after the market is going your way is a guarantee of a drawdown. Your trailing stop can easily turn an open-trade profit into a closed out loss.

3. Arbitrarily Targeting a Profit, Say $50 or $75
This is a strategy fraught with danger because of volatility effects. You run the risk of being a "noise trader", one who is active in the noisy part of the market. See Noise Traders If you are in the balancing phase of the market, you are in the noise and your trades are a flip of the coin. Except that win or lose, there are always costs. And you will always miss that occasional big move.

4. Exiting on the Close
For a day trader, this is a must. However, do you really want to exit with a MOC order? If there is a closing range, the executing broker may have the option of giving you any price in that range. You might consider exiting, e.g., ten minutes before the close. An advantage: there is no drawdown.

5. Exiting at a Resistance or Support Point
This strategy may well lose the big fish. Say you go long below a major resistance. The trade is good, moving up to the resistance. Everyone knows it is there. Some selling occurs, but price does not swoon. If price breaks through, it may go to the moon. You would like to be with it. In a case like this, more information is necessary. A way to get that information is discussed in item 7. Blindly exiting will remove you from the potential for a large gain.

6. Exiting if the volatility widens or narrows
Volatility is a market reference point that you can monitor throughout a trading day. Volatility and Stops for the DayTrader Normally, volatility increases markedly in a strongly directional market. A decrease in the volatility is one sign of congestion (see 7.). This sort of micromanaging requires more information than the average trader has. Further, measuring volatility on the fly is hard to do accurately.

7. Monitoring Congestion with an Exit if it Grows Too Large
Congestion is probably the strongest measure of a market's directionality. Congestion Measurement for Exits Markets go through an everlasting cycle of balance to trend to balance to trend and so on. The Market Unit The balance phase is congestion. The trend phase is directional movement. You need the movement to make a profit. However, all moves ultimately end in a balance, a congestion. If you are to maximize your gains, you want to be able to read the trending phase. A trend runs (high volatility, low congestion), then it pauses (lower volatility, higher congestion), then it runs and pauses and so on until the last pause which is the start of the new balance. The first pause will be the last pause in a short trend. Market Profile/Meta-Profile is the data tool that allows you to measure congestion.

Once you are in, presumably on a breakout, you immediately become a congestion detective. As soon as congestion is large enough to meet your criteria, you exit. There is little drawdown. You have exited in the best spot you could find, relying only on your own market knowledge. Win or lose, you have practiced quantitative profit taking.