One of the questions that was repeatedly asked at the CMC presentations was: How do you know when to take profits?
The background to the question was the story I told about a relative whose win rate is 90% over a trading period of 30 years. Impressed? Well, what if I were to tell you that in that period, he has never made any money in any calendar year? Still impressed?
The reason for his net loss can be found in the Expectancy formula:
(Average $ Win x Win Rate) – (Average $ Loss x Loss Rate) MUST Be > 0.
In his case, he grabs small profits and incurs large losses so that the sum of his expectancy produces a negative result.
The question thus arose, to avoid this trap (I call it the Expectancy Trap), when should we take profits? In my view there are two standards:
- Mathematical and
The mathematical relies on the size of the initial stop and the Maximum Adverse Excursion, The initial stop is the profit benchmark; you cannot continually take profits smaller than your initial stop. The lower the win rate, the truer is this statement.
My initial stops are chart based but I do rely on a few statistical studies.
The MAE tells us if the stops are too close. In addition I use another parameter that I read in Ed Ponsi’s book, Forex Patterns and Probabilities (Forex Patterns and Probabilities). In the work, he suggests we run a simulation of losing trades with a series of higher stops. For example, how would the trade have turned out if we had increased the stop by 10 points (pips), 20, 30 etc to 50.
These technicals and mathematical studies help us determine where to place our initial stop. The first step is avoiding the Expectancy Trap.
You cannot avoid the mathematical certainty of long-term failure if our expectancy is negative. We have less control of our win rate than the Avg $ Win and Avg$Loss; so it behoves us to consciously ensure that we don’t consistently take smaller profits than our initial stop losses.
The technical benchmark tells us when we need create an exception to this general rule i.e when to accept a lower profit. After all, part of the function of a trading plan is to tell us when the probabilities for a trade no longer favour it or at least, tell us when the probabilities favour a partial exit.
An example of this assessment recently occurred in my Soybean campaign. I had pyramided my Soybeans shorts at 1286 basis September 08. My stop was above 1305.75. The market declined to 1242 and started to stall. My view of the technicals was there was a moderate probability of a bounce returning to 1280 to 1300.
If we compare the stop to the profit target, we see the stop was 21 points. To cover the first third (see Rule of 3), I’d need 42 points i.e. an exit at 1244. But on Tuesday when the market got down to 1243, I was sloppy with the timing of my order to exit at 1244 and as a result missed the 1244s. The question was, now that 1244 was no longer available, what should I do?
Given the technical assessment, I covered 40% of the position at 1256 rather than risk the bounce. Once I exited the 40%, I was on a risk free trade for a target to the Primary Buy Zone 1120 to 1176.25.
Figure 1 shows a chart of the trade.
FIGURE 1 Soybeans September