Getting Better at Taking Profits

A problem I've always had is taking profits. I've always been good at letting winners run, but part of being patient means accepting the reality that some winners will come back on you. It can be psychologically taxing to watch a big winner devolve into a breakeven trade. Based on some successful intraday traders I researched, I have an unconfirmed belief that I would be vastly more profitable if I repeatedly took "singles" instead of holding for home runs.

However, I think this is more of a mathematical problem stemming out of incomplete-information, rather than a psychological problem of being too greedy. It really has to do with how intraday stock returns are distributed.

Below is an image of some distribution shapes:

If stock returns had a distribution in which home run returns occurred relatively frequently, then the EV maximizing decision may actually be to hold your winners until the end of the day. It would be normal for some trades to come back on you. But there would be so many home run trades that they would more than compensate for those scenarios.

However, I have realized that is not the case. Our experience and intuition makes it clear that a $2 stock going to $10 is a rare occurrence, and even rarer still that I will be in that stock. For the vast majority of trades I enter into, the home run never occurs. In reality, taking smaller, consistent profits would be a higher EV route. Embracing this decision means that you MUST recognize that you are giving up home run potential and not beat yourself up when those home runs happen without you.

However, the question remains of where do you take those smaller profits? It's common knowledge that your average winner should be larger than your average loser. It's also common knowledge that you should sell into strength and cover into weakness. But beyond those platitudes, there isn't much more to go by.

Lately, I've come up with the concept of using ATR(X) divided by 3 in order to come up with a maximum profit target in order to force myself to close out positions. ATR is the average true range over X periods. The number I use for X is how many days the stock has been in play. 

This formula does not work if you are trading the first day that a stock has been in play. If you are lucky enough to be in on the start of a move, then your guidelines are the past ranges that the stock has been able to produce in the past, along with the size of the float, etc. I am more likely to hold into the close on day 1 if I have a great price.

However, if I am trading a stock after the day 1 move I begin to rely on my formula. On day 2, my formula would be ATR(1) divided by 3. In other words, I would take the ATR of the day 1 move and divide it by 3. That is my MAXIMUM profit target. I force myself to get out of that position if I am up by that much. Of course, I can always get out of the position before that target is reached.

This formula has the advantageous aspect of reducing my maximum profit target if the range of the stock decreases over time. It also allows me to capture profits as the stock begins to fall out of play and becomes less volatile. It also keeps me from holding positions longer than I should, especially on days in which there is a greater chance that the momentum may reverse on me.

I calculate it for the stocks I am monitoring the night before.