Profit taking stock trading strategies

"In summary, people trade for both cognitive and emotional reasons. They trade because they think they have information when they have nothing but noise, and they trade because trading can bring the joy of pride. Trading brings pride when decisions turn out well, but it brings regret when decisions do not turn out well. Investors try to avoid the pain of regret by avoiding the realization of losses, employing investment advisors as scapegoats, and avoiding stocks of companies with low reputations." (Meir Statman)

Psychologist, Dr. Daniel Kahneman (The Nobel prize in economics - the field of behavioral economics) basically shows that investors are irrational, but predictably irrational. They continue to make the same mistakes over and over. One of the biggest is a common inability to take a loss: taking a loss is so painful, it is simply avoided.

Professor Statman from Santa Clara University is an expert in the behavior known as the "fear of regret." People tend to feel sorrow and grief after having made an error in judgment. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment. The embarrassment of having to report the loss to the IRS, accountants, and others may also contribute to the tendency not to sell losing investments. Some researchers theorize that investors follow the crowd and conventional wisdom to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalize it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalize if it goes down.

A trader’s most valuable commodity is trading capital. What is the most important rule for a trader? Preserve your capital. This is what keeps a trader in the game, and it is foolish to do anything that will jeopardize it. Subsequently, to preserve a trader’s capital, there are rules that help a trader, whether in short, intermediate or long term play.

The rules listed below are suggestions. Only the trader can decide which rule is important. However, when a trader decides on a set of rules, they should be used consistently. Rules make up a trader’s system and are enforced by discipline.

1. Never be willing to let a position go against you by more than 5 to 8%. Obviously, the amount will differ depending on if it is a short, intermediate or long term play. If it is a short-term play and you have not set a distinct stop/loss, then you might want to set a dollar amount based on your capital. For example: If your capital is $60,000, you might not want to lose more then 1% on a short term trade. This also depends on what is happening with the trade and the market at the time. However, you should ALWAYS have in mind where you WILL get out of a trade. Don’t fear cutting your losses. Just cut them and move on.

2. Always take at least some profit at 20 to 25%. This is an important concept. When in doubt, take some profit. When the stock comes down again you can always get back in. It is the trader’s decision to select a higher or lesser percentage. Of course it all depends on the market and the trade and how comfortable you are with the trade. Doesn’t it make sense to take something off the table in case the stock goes down? This technique is a good way to control greed. If you are disciplined enough to cut losses at 5 to 8% no matter what, and you are taking some profits at 20 to 25%, mathematically how can you lose money?

Pyramiding

3. When your stock has demonstrated its ability to move in the desired direction, you should take further action by raising your stop/loss point to break even. At this point, allowing a winner to fall back into losing territory is just not smart, no matter what the reason. We work hard enough being right in the stock market without allowing the winners to turn into losers. By raising your stop/loss to break even ALL of the risk is taken out of the trade. At this point you can literally relax and enjoy the trade. One cannot begin to tell how psychologically important this rule is. Once a trader realizes that money can no longer be lost, a tremendous calm and clarity begins to engulf his or her mind. A sense of control and power evolves as the trade moves on. You can move your stop/loss continually higher and you become more comfortable with the trade.

Profit Stop/Loss Method

4. Decide at what percentage you will take profits, etc. You might decide to protect 3% of your profits when the stock rises 10%. Once a stock rises 15% you might decide to protect 10% of your profits. When your stock rises to your target 20 to 25%, revert back to rule #2. You must decide what is comfortable in the profit department. The important thing is to make some decisions. Make those decisions a part of your system and govern your system with your discipline.

There is no question that if you are disciplined enough to follow a plan such as the one outlined, it will improve your results. However, most people will not follow rules. Why? Most people cannot stick to rule #1. Winners cut their losses short and move on to the next trade. Also they hold no grudges against any security. Losers hold on to falling stocks mostly because of psychological issues until making a rational decision has long since disappeared from their psyches. Only time will tell whether you have the inner strength to become a winner.

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