Cutting profits

... and letting losses run

Recently, TD Ameritrade sponsored a free seminar for Apex clients (that's me) on trading risk management. Hey, it was free! As I suspected, there wasn't a lot new presented, but it did rearrange some of what I already knew in ways that got me to try some new tactics.

possible outcomes of a trade

One statement made a direct hit: Quite often, traders cut their profits and let their losses run. Wanting the BIG GAIN, but ending up with the BIG LOSS instead. Oh yeah, that's me. When a stock is going up, I get nervous and think, "I'd better sell and lock in those profits while I can." When a stock is going down, I find all sorts of reasons to believe "it might go back up." The result is that most of my profits are modest, and many of my losses are painfully large. Enron comes to mind: bought at $90, sold at 16¢.

I was reminded of all this today when I saw the earnings report for CKE Restaurants (CKR), which once again blew away Expectations. In 2004, I bought CKR at $11.35 and delightedly sold ten days later for $13.35, a profit of $2 per share.

CKR stock chart
CKR 3-year chart

Unfortunately, I left a lot of money on the table. Today, CKR is trading around $19 (see above). The 5-year trend is clear; CKR is going up! (see sidebar). An even more dramatic example is Hansen's (HANS).

There is a way to avoid taking early profits and late losses: use a trailing stop. A stop order (aka stop-loss order) is one with a condition attached: if the price goes below (or above) a certain point, sell.

Those who've been following along know that I've tried this before and been terribly frustrated. Too often, my order would be triggered by an unusual outlying trade, and I would end up closing the position prematurely. So, I gave up on them and tried to use "mental" stop-orders instead. But that takes real discipline, and it's easy for the emotions to overrule the brain.

Looking back, I realized that there were two root causes of my problems:

  1. I was timing my buys poorly, often jumping in at the end of a short-term uptrend rather than the beginning
  2. I was setting my stops too tight, triggering them by intraday volatility.

So, I've gone back to placing real (not mental) stop-loss orders as soon as I make a buy. I use a trailing stop defined as 10% of the purchase price per share. For example, if I pay $13.65, the trailing stop is set at $1.37, and if I pay only $5.50, the stop is $0.55.

How it works
QLTI 1-month chart with trailing stops

Bought QLTI 21-Sep at $7.50. Using 10% of the purchase price, I set a trailing stop of $0.75, making the activation price $6.75. If QLTI traded at or below $6.75 it would have been sold for a loss of about 10%.

On 6-Oct QLTI hit a new high of $8.14. With each new high the stop has trailed upward, making the new activation price $7.39 ($8.14-0.75). If QLTI were to fall to that price or lower, it would sell, and I would still incur a loss, but only about 1.5% (.11/7.50 * 100).

If QLTI continues to set new highs, the activation price will ratchet upward and a profit will be protected. Note that as the price rises, that $0.75 stop becomes a smaller percentage of the current price, in effect tightening the stop. For example, if QLTI were to double in price, to $15.00, the activation price would then be $14.25, just 5% from the current high. That would be a nice profit, indeed.

As for the problem of buying at the wrong time, I now screen for stocks "trying to reverse a long downtrend" (defined in Advanced Analyzer as "near the middle of their 52-wk trend that have moved up at least 5% over the past five days"), and make buys from this pool only when certain technical conditions are true:

  • Price momentum (PPO) — rising
  • Trend (ADX) — rising or level and buying pressure (+DI) above selling pressure (-DI) and rising
  • Money flow (CMF) — flowing into the stock or improving steadily
  • Relative strength (RSI) — rising
  • Volume — average volume increasing or higher-than-normal volume on price jumps

Faithful followers of Trader Paul will recognize these as the conditions called out whenever I buy a stock. Faithful followers will also recognize that Trader Paul sometimes makes exceptions and quite often regrets them later.

So far, it seems to be working. I've recently gotten stopped-out of some stocks that in the past I might have been tempted to hang onto. For example, see VPHM, SCUR, or WPL. Meanwhile, I have let ELP run longer than usual, with unrealized profit well into double digits.

Back to CKR: Looking at the CKE chart again (below), it's clear that if I had been setting a 10% trailing stop when I bought, I would have gotten stopped out before too long. But, if I had been paying attention to the long-term chart (sidebar), I probably would have jumped in again and continued to make profits along the way.

CKR 3-yr chart

Even if I had not bought in exactly at each new low, there would have been at least three opportunities to pile up additional profits before getting stopped out each time. Each buy at a higher price would have created a bigger initial stop. It would have been a banquet of $6 burgers!