over the last 30 years. But what I’ve found is that you can go broke taking
a profit.
Every method has a certain number of losses and a certain number
of gains. That is the nature of every method. There can be variances
around that number for short periods of time but not over the long run.
Let’s go back to our example of losing $1.00 on each losing trade and
making $2.50 on each winning trade and 45 percent of our trades are
winners.
We know through simple math that this is a winning method. But what
if we took profits every time we had a $1.00 profit? That would make this a
money-losing method immediately. We are losing on more trades than we
are winning so making/losing equal amounts of money on each trade is a
surefire way to lose money.
Realistically, though, taking quick profits will likely boost the number
of winning trades to losing trades. This may be enough to make this a profitable
system. However, we would have to boost the number of winning
trades compared to the losing trades by a large amount to equal the profits
of the original ratio.
All methods have losing trades. That is the price of playing the game.
We need a certain number of winning trades of a certain size to pay for
those losses. The winning trades that are beyond that level create the profit
for us.
Every method has a natural profile of winning and losing trades, their
size and frequency. Let’s assume that you are using a winning method.
Cutting the size of the winners will usually cause a higher number of
winners but at a much smaller size. I may cut the size of the winner from
$2.50 to $1.00. The average size of my winner is now just 40 percent of
the previous size. That means that I must have 150 percent more winners
than I did before to equal the dollars that I had made before in my trading.
Remember that I was making only 45 percent of my trades as profits with
the remainder being losses. Adding 150 percent of the 45 percent winners
would mean that I would have to have more winners than I have trades to
equal the profits of the original method. That’s impossible.
Basically, the base method lost on slightly more than 50 percent of
the trades but the winning trades were 2.5 times the size of the losing
trades. It is impossible to make as much money as this method if I cut
the profits to only 1 times the size of the losing trades because I would
have to have more winning trades than I have trades to make that much
money.
It comes back to the old trading adage of letting your profits run and
cutting your losses.
We need to be careful when we take profits too early. Most of the
techniques in this book are trend-following techniques. That means that
we want to follow the trend as long as it is trending. Generally, we have
no idea of how far a trend will go. So we want to give that method
as much room as possible to let the trend make us as much money as
possible.
Basically, we let the trend run until we are stopped out. I have said
that protective stops should have two attributes. First, they should filter
out random noise. We don’t want to be stopped out because of some blip
in the market, only because something significant has happened. Second,
we only want to be stopped out when we are wrong.
In the case of a trend-following technique, we only want to be stopped
out when the trend is no longer our friend and the market has turned neutral
or bearish. So why would we ever want to take profits before getting
stopped out? There are two reasons: psychological profits and confirmations.
We’ll explore both in the pages that follow.
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
