A question often asked by investors and traders: when do I sell my stocks?
Trading is slightly different to long term investing because usually investing is not leveraged, whereas trading often is. Because of this it’s necessary to position size and set a stop loss with trading, so that too much money is not lost on one transaction.
The use of a stop loss means exits from a stock is automatically done by a broker should price tag the pre set stop loss level.
In this article, I’ll be looking at the difference between a trailing stop loss and a profit target.
Profit targets are usually pre set before a trader takes a position. A target is a preset price that your broker will exit your position automatically should price tag that level. As the name suggests a profit target is specifically the level that will exit your trade for a profit, not a loss as with an initial stop loss.
For example, let’s say you wanted to buy shares in Apple at $300. You may set a stop loss at $295, meaning your broker will exit at $295 for a loss should price reach that level. Your position size determines the size of the loss – i.e. the number of shares you buy. This order than may have a profit target at $310, meaning $10 price increase in Apple will result in your trade being closed for profit.
Using profit targets is usually a method Day Traders use. If these targets are used at logical levels, such as support or resistance then this makes sense. Some of the time price may well reverse at these levels. This means you’ve exited your short term position at the best place. However, I always trade (both short term and long term) during market trends. When a trend is making new highs (or lows), there’s a good chance that price will continue and break that support or resistance that the target was at. Often then, price will in fact continue, meaning you’d have missed out on significant profit if you limited your position with a profit target.
I used to use the above technique for my swing trading strategy. And it worked. But after testing the same strategy with a trailing stop loss, my performance increased dramatically.
A trailing stop loss is where you move your stop loss to follow price as it moves in your favour.
Below is an example of a recent trade I took using a trailing stop loss. You can see my stop loss (dashed red line) is above my entries, meaning there is profit locked in.
Charts courtesy of TradingView.
Revisiting our earlier example, let say we entered Apple at $300 with an initial stop loss at $295. Instead of taking profit at $310, this time we’ll move our stop loss to $5 below current price. If price does in fact reverse at $310, then we’ll only profit from a $5 price increase instead of $10 with the target example. However what often happens in trends and larger market moves is price will keep on going. Lets say price gaps up and reached $330. This means we move our stop loss to $325 at the end of the session. If price were to reverse at this point, then we’ve banked an extra $15 price increase. Achieving this just by being more patience and not trying to exit at market tops.
The trailing stop loss level does mean you’ll never exit a market right at its top. However more often than not you’ll miss out on further profit my limiting yourself to a target. During my back testing those trades that resulted in less profit by using a trailing stop loss more than pay for those stocks that went on to go 2,3, or even 4x further than where the logical target would have gone.
In summary, from a trading point of view, there are 2 main exit techniques. Using a set profit target or using a trailing stop loss. Of course there is a 3rd option, which is if price tags your initial stop loss for a loss.
From my extensive testing and experience, I always use a trailing stop loss – meaning I follow price with the stop loss. This technique does not limit your trade to a predetermined profit or risk:reward ratio. Instead it allows the strongest trades to accumulate far more profit than a target would allow. This year alone, I’ve profited from a 7R (7%) and an 11R (11%) trade. This means I grew my trading account by 18% with these two trades alone. Most logical profit targets wouldn’t have allowed for this.
So which is your prefered exit method?
The actual logic behind my trading strategy and trailing stop loss are out of the scope this article. But if you’d like to know more, feel free to get in touch:
Thanks for reading!