One of the many enjoyable things for me in learning about and trading the markets is the variety of colorful cliches that point out some little piece of wisdom (mostly) or other. "You can't go broke makin' a profit," for example, can remind us that it may be a better idea to take profits at some time before they turn into losses. But how does that fit with "cut your losses and let your profits run?" The key in both instances seems to me to be the undefined "when" that signals the time to take the profits. Even if we can't go broke makin' a profit, it is certainly better to let those profits run as long as they actually are becoming increasingly profitable.

In my dealings with coaching students and with other traders, I have seen that traders may learn relatively quickly to cut losses, but have a little more trouble letting profits run. There also seems to be a tendency to take profits relatively quickly as well. Naturally, if that is what we are doing, we can't go broke -- UNLESS our losses outweigh the profits. Both the sayings are important in that they invite our attention to what we should be doing. The how and the when are what deserve our study.

As with many things in trading, there are a number of ways to achieve the goals of not going broke, cutting our losses, and letting our profits run. Unfortunately, it is too often the case that the trader listens to the little voice in his head (the emotions) to make trading decisions. I have seen that the voice in the head method regularly can lead to cutting profits and letting losses run. It seems clear to me that something else is needed. The key here is discipline and one way to establish discipline is to use a line on a chart. For example, if we take any chart of the movement of a stock price and overlay a moving average we can visualize a disciplined entry and exit strategy. Suppose we choose a 20 day exponential moving average and we decide that we will enter a bullish position when the price crosses above the moving average and that we will exit when the price crosses below the moving average. Now we have a simple discipline. Does it work? Take a look at any chart with a moving average overlaid yourself and you will see that the method catches many nice uptrends and if you also play bearish many nice downtrends. In between, you may also see several areas where you would be whipsawed in and out of a trade incurring, perhaps, a number of commissions. One weakness of the methodology is the risk of whipsaws while a strength is that the method keeps us in the game while the position continues in the favorable direction. In any event, you can get an idea of how such a technical discipline using a moving average may be more helpful than the voice in the head method.

Actually, moving averages are forms of trend lines. We can also draw lines depicting the trends ourselves and use them in similar fashion to enter and exit positions. By learning to utilize devices such as these we may be able to enjoy the benefits of another old market cliche, to wit: "the trend is your friend." Simply put, if we can find a trend we may be able to jump on and ride it until it is broken. That, at least, may be one way to let our profits run.

I suppose we can improve our trading when we come upon some of these cliches by giving them some thought instead of just letting them go by. There is wisdom in many of them if we can find a way to accomplish what they suggest. Perhaps the most important one of all to remember as we trade may be: "Bulls make money, bears make money, but hogs get slaughtered."

Good Trading!
Bill Kraft

April 4, 2009

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