Regardless of how careful a trader is in planning a trade, there is no guarantee
that the market will reach the intended profit target. Occasionally
the market will come close to a profit target only to reverse direction and
move quickly against a trade. There is nothing more frustrating than setting
a trade in motion only to find out later that you could have taken a profit
but ended up with a loss.
To combat this problem, traders deploy a number of techniques to
capture some profits quickly and remain in the trade, hoping to capture
more. These techniques are great when a trade fails to reach its intended
profit target, because the trader at least captured some profit along the
way. Unfortunately the devil is in the mathematical details, and what
appears to be a good idea on the surface often causes unintended consequences.
Moving stop orders to breakeven or scaling out of a winning
trade by reducing the position size as profits are accumulated can actually
increase volatility in your trading returns. These techniques assume that a
trader has a high percentage of successful trades because each trade takes
on more risk in its initial phases than it takes in profits, even when the
intended profit target is reached.
In this section we look at two common techniques often used for
managing profit that can actually do more harm than good in many
cases.
Moving Your Stop to Breakeven
Arguably the most common technique traders deploy to protect both their
profits and their exposure to risk is the breakeven stop loss. Once a position
is “in the money” or showing a meaningful floating profit, traders often
move their protective stops to breakeven, assuming that they are protecting
their capital by mitigating any risk the trade may bring. The breakeven
stop is also seen as a way to manage profits by protecting any gains the
trader has made on previous trades by, again, mitigating the risk of any
trades still open. In fact, many trading systems encourage getting a trade to
breakeven as quickly as possible to reduce the risk proposed by the trade.
Since booking a profit is never a guaranteed event for any trade, moving
your stop to breakeven might seem like a good idea, but in my opinion it
is rather misleading advice. Each trade must assume a certain calculated
amount of risk to potentially enjoy taking in a profit. Reaching that profit
target is rarely a straight move from entry to exit. The market oscillates
back and forth as it moves higher or lower, and often a trade is taken in
and out of a profit as the market moves toward the intended profit target.
Traders who move their stops to breakeven often get in the way of a
good trade, as illustrated in Figure 5.1. In this AUD/USD example trade,
the trader was taken out at breakeven. If the trade had been left alone, the
market eventually reached the traders’ intended profit target. This oscillation
in price happens frequently as the battle between buyers and sellers is
worked out on the way to a profit target.
Trading involves risk, and if you calculate your risk appropriately before
you enter a trade, you should be comfortable maintaining that level of
risk throughout the life of the trade. To reach your intended profit target,
you might have to endure some time in negative territory, even after being
at a profit. Remember, no trade is done until either the profit or the loss
is booked, so being afraid of “letting a loser turn into a winner” is actually
counterproductive to the health of your account if you maintain a disciplined
risk-to-reward ratio on every trade. Patience to see a trade through
to the end or as close to it as possible is a skill any professional trader needs
to develop. Let’s consider some example trades to illustrate this point.
Assume that two traders use an identical trading system. They both
risk 40 pips per trade and they both use a profit target of 120 pips, which
works out to be a 1:3 risk-to-reward ratio. In other words, they are risking
one pip for every three pips they expect to earn in profit on each trade.
The only difference between these two traders is that one moves her stop
to breakeven once she has made 80 pips in profit, and the other doesn’t.
Table 5.1 demonstrates how the practice of moving protective stops to
breakeven actually increases volatility in your trading results versus simply
letting your trade run over a series of 10 example trades.
The trader who used a breakeven stop did not suffer as many losses,
however, trade number two was taken out at breakeven when it should
have made a profit. In this case, the market touched the breakeven
stop order before ultimately reaching the profit target. This single trade
made a tremendous impact on the overall profitability of the trader using
breakeven stop orders. The results over 10 trades clearly demonstrate that
using a breakeven stop added 10 percent more volatility to the trader’s
account and earned her 40 fewer pips versus the trader who left his trades
alone.
With the results in Table 5.1 fresh in your mind, do not get the impression
that breakeven or trailing stops should never be used. Moving your
stop can be useful to protect profits when a trade is within a few pips of
reaching its profit target. Consider the scenario where a trade is 150 pips
in the money with only 40 pips left to the target. Is it really worth risking
150 pips to gain another 40? That is up to the trader’s personal appetite
for risk, I suppose. I personally prefer to set a trade and forget about it,
allowing my trade plan to execute.
The issue with breakeven stops is usually the way a trader executes
them versus how they should be executed. Many traders are simply too
aggressive with breakeven or trailing stops and do not allow the market
room to maneuver. Support and resistance can be used to improve the
chances that a breakeven or trailing stop will not be taken out prematurely,
but there is no guarantee. If you are comfortable with the additional volatility
that breakeven and trailing stops bring to your account, pay close attention
to the section in this chapter titled “Using Trailing Stops.”
Scaling Out
Another popular but flawed profit management technique is known as scaling
out. Traders scale out by closing a portion of their overall trade size
as the trade becomes profitable and continues to their profit target. This
technique allows traders to capture smaller profits faster while leaving the
position open as the market moves farther in their favor. There are many
different flavors for scaling out of a winning position. Some traders take
2/3 of their position early in order to use that profit as a cover for the risk
on the remaining 1/3 of the position that is still open. Other traders use two
profit targets, taking half of their position at the first profit target and the
other half at the second profit target. Regardless of how scaling out is done,
all traders who scale out of profitable positions share a common problem:
an imbalance in risk versus reward. When a trader scales out, the amount
of profit taken is rarely equal to the amount of risk assumed when the trade
is opened.
Consider a trader who trades 10 currency lots at a time and a 40-pip
stop loss. His total initial risk on the position is 400 pips. If the trader scales
half of his position out with a 50-pip profit, he will have covered 250 pips
of the initial 400 pips. The remaining position must be closed out at a profit
greater than 50 pips to maintain a risk-to-reward ratio of 1:1. Traders usually
exacerbate the problem by moving their stop loss to breakeven after
scaling out with some profit. If their remaining position is closed out at
breakeven, they have effectively risked 400 pips to gain 250. If their next
trade is stopped out for the full 400 pips, they have a deficit of 150 pips to
overcome on their next trade, assuming they are still trading 10 lots per
trade. The imbalance in risk-to-reward requires a trader who scales out to
maintain a much higher success ratio than traders who do not, because just
one losing trade can erase the profits from multiple winners.
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