Conventional wisdom is that no trader should take profits too early. To close a position while there is every chance that the asset in question has yet more profit to come, is to commit the classic error of “leaving money on the table”, a terrible mistake and a sure sign of a rank amateur.
It is like a television game-show guest who collects the first available winnings, however small, and heads home, or someone in a casino, who having won a few coins on a slot machine, shuns the big money available at blackjack or roulette, and cashes in their winnings.
Why are these people trading in the first place? They would surely be happier putting their money in a dull but safe savings account.
Professionals get out early
But is taking profits early an act of stupidity? The worst of all possible position trading strategies? Or does it in fact show wisdom?
Before examining the merits of running profits against the case for taking them, it may be worth looking at some basic facts concerning the market for securities of all types.
Asked who owns , bonds, and , most people would probably say big institutions such as banks, insurance companies, pension funds and so on. Now, it is true that these grand entities are temporary owners of financial assets. But the ultimate owners of all such assets are either individuals or trusts.
That’s right – all such assets.
This is of much more than academic interest. Why is it that the ultimate owners of financial assets in general seem to derive less benefit from them than professional traders working for the aforementioned institutions?
Experience and expertise play their part, and a key aspect of a trader’s skill is taking profits at the right time. By locking in the profits from an upswing, traders can sell the asset on to the investment managers (either working for their own or outside institutions) that look after retail investors.
The asset may or may not be over-priced and due a correction. Even if not, the professional traders – not those ultimate owners, the retail investors - are likely to have captured most of the gain on the price at which they bought.
Put another way, there is little joy to be had from being the “ultimate” owner of an orange if most of the juice has been sucked out by the time it reaches you.
On a theoretical level, it would seem that taking profits early is beneficial. But what about on the day-to-day level?
They may well also ask what place there is for “conviction trading” – taking positions on the basis of well-grounded beliefs about the asset concerned – when the trader is forever trying to calculate the best time to bail out?
This leads to a third objection, which is that profit-taking is based on the fallacious notion that an asset rises and falls in a predictable manner, and that a trader’s priority is to get out before the final peak, after which a downswing will set in.
In reality, a security can rise, fall and rise again, sometimes surpassing its previous peak. In such cases, a conviction trader will reap the rewards that a profit-taker will have lost.
The practical case for early profit-taking starts with the proposition that it is a powerful defence against greed. An apparent winning streak ratchets up the temptation to stay in a trade, not least to avoid feeling foolish as your fellow traders seem to be garnering endless profits.
Set a target – and stick to it
Taking profits early guards against getting caught up in the Gadarene rush, and pays due regard to the well-known words of British investment guru, the late Robert Beckman: “Markets will do whatever they have to do to ensure that most people are mostly wrong most of the time.”
Those sticking with a supposedly hot streak are “most people”. Taking profits too early is a way of not being one of them.
Being committed to taking profits earlier rather than later, requires some idea as to when that point will be. It could be instinctive, when the trader senses that the upswing has entered its final lap and it is time to sell. Or it could be highly technical, with the trader studying asset’s previous price performance and fixing a “sell” point at, for example, significant deviations above or below its moving average.
An old Wall Street adage states that a trader should sell securities, in this particular case shares, when they have delivered the gains the trader has been seeking – and then not look at the stock price for six months. That way, any self-recrimination arising from a continued rise in the price would be avoided.
Such an admirable approach would kill two birds with one stone: greed, and heartache.