Introduction
Aspiring traders and the majority of people think that if they had a crystal ball telling them the right entry point or the perfect stock to pick, that would be the key to succeed in the financial markets and become filthily rich. Nothing could be further from the truth.
Of course, entries are important, but no entry would save the investor or trader from market volatility. Novice investors and traders without the knowledge about how and when to exit will be wiped from their perfect purchases at the worst moment for them.
Most people focus on a frequentist way of looking at trading. Van K. Tharp calls it “the need to be right.” This need to be right pushes the investor to cut gains short and let losses run in the hope of a reversal that doesn’t always happen.
Daniel Kahneman in his book “Judgment Under Uncertainty: Heuristics and Biases” says that giving a choice of experiencing a string of small losses or one single huge loss, people prefer the second one. It also happens that what people enjoy most are frequent, although modest, gains; a lethal combination that transforms any winning system into a loser.
1. The mathematics of profitability
What you’ll read just below is the best-kept secret in the trading industry. The real holy grail of trading that explains the importance of letting profits run (achieving high Reward to risk ratios)
The critical feature of a good system isn’t the percentage of gainers, but its expectancy (expected value E).
Expectancy is the expected value of gainers (E+) less the expected value of losers (E-)
(E+) = Sum(G)/(n+) * %Gainers
(E-) = Sum(L)/(n-) * %Losers
Sum(G) is the total dollar gain in our sample history
Sum(L) is the total dollar loss in our sample history
n+ is the number of positive trades(Gainers)
n- is the number of negative trades(Losers)
The expectancy E then is:
E = (E+) – (E-)
If E is positive, the system is good. The higher E the better the system. If E is zero or negative, the system is a loser, even if the percentage of gainers were more than 80%.
There is another angle to this. If we switch our good-old brain to the right way a good trader should think -let profits run and cut losses short- we would be rewarded with high Reward to Risk ratios.
That is the right way to make our system resilient to a decrease in its percent of gainers.
For instance, a 2:1 RR sets the break-even point at 33.33 percent gainers.
Right! We need only one winner out of every three trades to break even. A 2.5:1 RR will bring the BE point down to 28.5% and a 3:1 RR will get it to 25%: Just one winner out of four trades.
There is no need to struggle with being right! We just need to make sure we follow our system, cut our losses short and let profits run! We can be blind chickens searching for corn grains!
Letting profits run requires patient and discipline. Jack Schwager recalls a sentence by Jesse Livermore: “it was never my thinking that made the big money for me. It was my sitting”. According to Schwager, “that’s a very appropriate comment. It means that you don’t have to be a genius, you don’t have to be smarter than anybody else, but you do need the patience to stay in the correct position.”
The “letting profits run” stuff seems to be aimed at long-term traders and nothing to do with short-term ones, but it’s false. Letting profits run is a way of thinking.
You may be an intra-day trader, but at least you’ll need a strategy or trading plan that uses some entry method and some profit target. In this context, letting profits run means allowing your trade develop until your profit target is reached (or close to it) and not letting your fears of losing trigger a premature exit compromising the Reward-to-risk of your system.
2. Trailing the trend
The usual way to let profits run is using trailing stops, and there are different methods on where to put a trailing stop.
There are systems not using any explicit trail stop. On those, the close of a position is marked by the system’s indicators. A reverse signal marks the close of the previous position.
1.- Trailing stops
The usual way to follow a trend is by trailing it with a stop at some level below the price action in long trades or above it in shorts.
The use of very tight stops at the beginning of a trade, until it proves itself, may lower the risk at the expense of being caught early. In this case, a re-entry plan should be considered.
You should be aware that to catch big trends you’re going to give back 25-35% of the profits at least once in that move. One way to deal with this is to break the position into three different chunks and set different stops and targets for each.
The use of stops based on price and pattern are common. Price movement has to do with levels. Once a level is surpassed there is a good chance it’ll continue to the next level. If price takes out a level and then flips back, like a false breakout, it’s a definite sign to close.
2.- Volatility stops
Volatility stops are located to avoid the “noise” of the market, by putting them below the recent volatility. For example, a trailing stop below the level marked by 1.5 times the 14-period average true range (ATR) keeps us in the trend most of the time.
3.- Trailing stops based on chart patterns.
Some traders use trail stops based on the latest pullback. They use the distance of that pullback as his stop distance. We may also use a pattern of higher highs and lows to put stops just below the recent low (or high if short).
When a market is moving up vertically a very reliable strategy would be a stop below the low of two to three days back (the same strategy on highs apply to down-moving markets).
4.- Trail stops and profit targets
Let’s say we started with a $500 money management stop let’s call this risk R. We should have defined a logical target at least 2R. As our trade develops in out favor we should consider moving our stop when we reach 1R: At that point, we are left with 1R potential profit, so we should at least move the stop to break-even.
As the price approaches our target, we must consider if the price momentum is improving or stalling, If the latter happens we should tight our stop to a level consistent with the principle of 2:1 reward to risk. For example, if what’s left is 0.5R, it’s unreasonable to risk 1R. The idea is to reassess the reward to risk ratio of what we think remains as open profit.
7.- Multiple methods
Two interesting methods are mentioned in Bruce Babcock’s book “The four cardinal principles of traders”:
Steve Briese, one of the traders, interviewed by the author, states that every trader should have a price objective. The objective shall be set based on the length of the trend. An oscillator of half the length of the trend can be used for this. When it becomes overbought on a long trade it’s advisable to exit a portion of the position, letting the rest ride the trend using a trailing stop.
Jake Bernstein spoke about a channel method to generate entries, which says, it will keep the trader on the right side of a trend.
That indicator consists of a moving average channel composed of a 10-bar MA of highs and an 8-bar MA of lows. The trend turns up when two successive bars are entirely above the top MA. It remains up until two consecutive price bars are below the bottom MA. The trade is kept until the indicator reverses.
Another way to lock profits would be, he says, to buy insurance in the form of options in the other direction (puts on longs, calls on shorts).
3. key points
- Let profits run is a crucial ability for a successful trader
- We should pursue Reward to risk ratios (RR) greater than two rather than high frequency of gainers at the expense of high RR.
- The use of trail stops is a standard method to let profits run, but an exit can be triggered, also, by a reversal signal or volatility in the opposite direction.
- Trails come in different flavors: recent retracement point, latest higher low or high, the crossing of a moving average or the price moving out of the channel in the other direction.
- It’s ok to set targets based on the price action, but the trailing stop must be moved to where RR is within the 2:1 concept. It doesn’t make sense to risk 2 to get just 1.
- It is advisable to computer-test our idea of trailing to optimize it.
2. conclusions and criticism
The concept of let profits run is nice, but a short-term currency trader must adapt it and test it, through back and forward tests, and make it his own system like a suit.
The use of trails stops must be carefully tested against fixed stops and targets, but the concept of Reward to risk ratios is Key.
A system with 2.5 – 3 :1 and 40% gainers is preferable than another one with a 1:1 ratio and 65% gainers because in real markets it’s usual that a system underperforms its back-tested values. We see that the system with 2.5:1 RR has a lot of room to allow for underperformance and, still, being profitable.
The only drawback of low percentage gainers is longer losing streaks, but, as we said, we must train our mind to be committed to the plan, and accept losing streaks. To achieve the right state of mind, we should trade small at the beginning and let the system prove itself.
3. appendix
Python code to play with Reward to risk and Percent gainers
The code takes % gainers (PG) and Reward to risk ratio(RR) as inputs and computes the expectancy(E). A Break-even point between % gainers and RR happens when E approaches zero.
The figure above shows the break-even (E=0) for a 3 to 1 reward to risk ratio that is at 25% gainers.
You could work the other way around and find the percentage needed for a Reward to risk ratio less than 1. (Below the one required for RR=0.5: PG=66.6% or 2 out of 3 winning trades shall be winners to BE, as is to be expected)
