We recently talked about big trading Mistake #1: giving your losses more ‘room’.
And I warned you that Mistake #2 seems counter-intuitive to a lot of people…
…and is all the more dangerous for that!
They say ‘no-one went broke taking a profit’…
…but if you always cash in a small profit, how can you ever get a large profit?
And this is the essence of Mistake #2: taking your profits too soon…
A good trading system will never exit a trade at the top (assuming we are referring to a long trade)… because there is no way of knowing where the top is.
Have you ever seen a trade get so high and you think it cannot go any higher, only for it to continue on… and on… and on?!
Get out where you think the top is and you’ve left a large chunk of profit on the table.
If somebody tells you that they know where the top of the market is (or the bottom) I advise you to ignore them.
The future cannot be predicted because as yet it does not exist.
There are any number of factors that contribute to continually rising prices in the stock and commodity markets…
…and these cannot be predicted by any technical indicator, chart analysis or fundamental analysis.
The same goes for continually falling prices in the stock and commodity markets.
If you are in a short trade and the market is going down, you have to stay short until you get confirmation that the trend has changed.
Nobody knows where the bottom of any market is in advance.
‘No-one rings a bell,’ as they say!
This is why we have to leave our trades open when they are going in our favour and let our profits run until we get confirmation that the trend is over.
This means that we must necessarily never get out at the top (or at the bottom in the case of short trades) and must always give back some of our profits.
Is this always easy to do?
No – but it is important to remember that when a market reverses and starts eroding your profits it does not mean that the trend has reversed, only that the market is going against you at that particular time.
Most traders find it extremely hard to risk giving back profits and they therefore take their profits too soon.
This inevitably cuts out the chance of having big winning trades, which are of paramount importance to the profitability of a trading system.
This is why we need a trading system with specific rules and the discipline to follow that system.
The discipline to follow that trading system has to come from the trader.
Each trade must be taken as per the system and trades must be left to run until the predetermined stop loss is hit, at which point we must exit the trade.
…but they are NOT so easy to follow!
As we discussed in Mistake #1, when you have a losing trade the temptation is to give the trade a bit more ‘room’ in the hope that it turns around.
Traders find it hard to take losses and therefore move their stops back. This almost always leads to taking bigger losses than are necessary and has a drastic impact on the long-term profitability of the trading system.
Equally as hard is the prospect of giving back good profits so many traders take their profits off the table as soon as they reach a fair size.
This is fatal to profitable trading.
In trading you must do the hard thing. If something is easy to do, such as cash in profits, for example, it’s almost certainly the wrong thing to do.
Remember, one huge win pays for a lot of small losses.
A good trend following system will generate several large winners each year.
A good way to look at this is from the following example: Let’s assume that we are going to risk £200 on every trade. Our risk then is £200. For this example, let’s call risk R. Therefore 1R is £200. At worst we know that we will exit our trades with a 1R loss, as that is where we put our stops when we place the trade.
For our example we are going to trade Wheat. Let’s say that we buy Wheat long at 900 and our stops are at 850. Therefore 1R also equals 50 points. If the trade advances over time and we finally exit at 1400, we have 500 points of profit or 10R. If 1R equals £200 then we have a £2000 profit.
This in effect means that we can now have 10 trades that lose a full 1R and we will still be at break even. This is the dynamic in action of cutting losses short and letting winners run.
During the course of the year it is not uncommon to get several winners that pay 10R or even more.
In addition to this, if your trading system is set up correctly, not all losing trades will lose a full 1R as sometimes the stops will have been tightened before exiting and you may only lose 1/2R on some trades or even less.
This increases the edge of the trading system and increases the positive expectancy as it keeps the losses much smaller than the winners on average.
If you always cash in a small profit you can never get a large profit.