No matter how well you enter a trade, if you never take a profit then it is all for naught. Like fishing, stories of the one that got away mean absolutely nothing compared to the big fish sitting in the frying pan. Back in 1999 an older brother of mine was sitting comfortably on over a million dollars in stocks and stock options. That is until the tech boom bust occurred in 2000. Within a few short months his wealth was reduced to a fraction of what he once owned. The impact on his financial security was so great that he even had to sell his multi-million dollar home, unfortunately before even the housing boom got underway where he might have made up for some of his losses. Like so many others, he didn’t see a need to take the money and run, he just thought it would continue to increase in value. He didn’t see a need to take a profit.
All good things come to an end and this is particularly true when it comes to market growth. Markets go through cycles where they increase in value and then the bottom falls out. Eventually they grow in value again, but they don’t always reach prior levels as anyone that happened to own NASDAQ stock during 2000 can attest to.
Taking a profit is more important than the original entry, but most new traders tend to focus on techniques for entering a trade and ignore the exit. Unfortunately, many courses and books on trading only help to promote this failing since many never stipulate a means of exiting other than simply when a stop limit is exceeded. Exiting therefore becomes more of a loss prevention strategy rather than any intentional effort to maximize profits. So then, how and when do you take a profit?
First, it is important to understand that there are numerous techniques for determining when to take an exit and there are entirely different reasons for taking one as well. This is not a “one size fits all” matter. An exit to control losses is still invaluable and should always be part of your trading. What we are focusing on here is a different kind of exit, a proactive approach designed to capture profits before they slip away. Some of these approaches are based on reaching preset profit levels and some on either momentum or over-bought/over-sold criteria. In practically all of these methods an exit typically occurs either too early or too late, but the benefit is that a profit is actually taken out of the market and the inevitable vanishing act created by a market retracement is avoided.
Profit-taking is not about capturing all the potential profit, it is about making an actual profit while a trade is still profitable. It is important to understand the difference here. This means that a profit-taking exit will at times have you out of a trade while it is still producing and you will miss out on anything additional that it produces. Consider this a trade-off the next time you watch a profitable position slip away and turn into a loss.
In order to maximize potential profit, some traders will choose to enter with multiple contracts, shares or lots and as the criteria is reached for a profit-taking exit they will only exit partially, allowing the rest of the trade to potentially accumulate additional profit. This may include secondary profit-taking levels or even third, fourth or more. Other traders choose to exit their entire trade as soon as it reaches their profit-taking criteria. However a trader chooses to handle profit-taking, in all cases an additional and separate exit order that serves as a stop loss will always be in place just in case the profit-taking point is never reached.
So how do you determine your profit-taking criteria? Several methods can be applied, such as a set percentage or profit gain. For example, while trading the S&P e-mini a trader may set a profit-taking level at 2 points, which equates to $100.00 per contract. If you bought at 850 then you would exit at 852 irregardless of how strong the bullish trend might be. If the market moves to 856 then you will miss out on the additional $200.00. Even so, you would have made a $100.00 profit while you could. Many a trader would have stayed in the market until it reached 856 only to see it drop back down to 848 for a $100.00 loss, where their stop limit was set. No matter how far the market moves in your favor, it means nothing unless you are able to actually take the profit.
A method that I personally have found very effective is that of using channels. Using a channel can be as simple as drawing a trend-line, duplicating it and then placing it on the opposite side of a price trend. For example, during a bullish trend a trend-line is drawn off of the lows that have the greatest clearance and encompass all the price bars. Then this line is duplicated and placed on the high that places this line furthest out and clears all other highs within the trend. If a price bar reaches this upper line then a profit-taking exit is signaled and taken. Although the upper line is nothing more than a duplicate of the lower line’s angle, it is amazing how often price will react strongly by declining immediately following price’s contact with it.
An alternative choice is that of using either an over-bought/over-sold indicator or a momentum indicator. Divergence is a valuable part of using either of these, so if you choose this route make sure you understand how divergence works. As is true when using any indicator, it is imperative that you establish the very best optimize setting for the market and time frame you are trading. Most indicators have various settings and will require frequent adjustment or otherwise you are likely to see the quality of the signals degrade. Typically, the very best profit-taking indicator and setting will be quite differently than the best entry setting. What you use to enter a trade is not likely to work well for profit-taking.
Others find that using support and resistance levels is also good for profit-taking signals. Using prior highs and lows where the market reacted previously tends to be a reliable indicator of when a trend will stall or even come to an end. However, keep in mind that price will not always react exactly at prior price levels. It is prudent to allow a range for variation and take profits slightly before price hits a prior high or low level. For example, with the S&P e-mini you might have bought at 850 and the market is moving higher toward a prior high which topped out at 854. Often it is better to take an exit a little lower, such as 853 . A prior high will typically bring a strong reaction and this can bring a very challenging exiting situation. A few examples of what could happen if you wait until for price to reach 854 are:
1. Traders will not allow price to actually reach 854 at all, so it fails to ever reach it
2. It reacts so fast to reaching 854 that can’t get an order filled at that price
3. It drops so fast after reaching 854 that price is below 852 before you can ever get an order filled
Allowing a range of plus or minus on the conservative side will increase the odds of being able to actually take a profit, which is the goal of profit-taking in the first place.
Profit-taking is an important tool that every trader should add to his or her trading arsenal. The thrill itself may have been what initially attracted you to trading, but sooner or later every trader needs to make a profit. As you probably already know, the market really doesn’t want to give up any of its money to you so don’t expect it to. Instead, why not take matters into your own hands and actually take it from the market yourself?
Go ahead, take a profit!