How many times have you exited a stock after it doubled, only to see it rise another 500%? Or worse yet, sold one of the greatest gold stocks in history for a $13 loss right before it experienced a meteoric rise from mere pennies to nearly $30 a share (CEO.ca founder @Tommy threw away a Picasso when he sold his Great Bear shares for pennies in 2018)?
What is the perfect formula for knowing when to take profits on a trade, and when to sit tight and let the profits run?
This question is the trading version of "Is there a God? And what is the origin of the Universe?"
It’s the holy grail.
There is no perfect answer, but in this blog post I will delve into this in hopes of raising our awareness of tendencies that cost traders money over and over again.
The amateur trader has a tendency to take profits fast and to allow losses to grow larger. The desire to 'be right' is at the root of this innate human tendency to not want to sell a stock at a loss and to lock in a gain at the first sight of green.
However, our human instincts are often our enemy when it comes to financial markets because we are hardwired to do the wrong things when money is at stake.
The topic of risk management and being disciplined in taking losses has been explored ad nauseam. I am more interested in exploring the topic of allowing profits to grow larger on profitable trades and suppressing the instinct to lock in gains too early in a trade.
Twenty years ago, when my trading journey was just beginning, I read the classic "Reminiscences of a Stock Operator". The book was entertaining, but some aspects only really clicked for me many years later. One of Livermore's favorite concepts was how important it is for a market speculator to be able to capture the lion's share of a move by being able to do nothing.
Examples from famous quotes attributed to Livermore: "It never was my thinking that made the big money for me. It always was my sitting." and "men who can both be right and sit tight are uncommon."
Livermore at his favorite vacation destination, The Breakers Hotel in Palm Beach, pictured at a time when he was near the peak of his powers
This seems like a simple concept at first. After all, how hard is it to simply go to the beach and resist the urge of opening your brokerage account and pressing the SELL button?
Anyone who has actually traded knows that there is always a strong temptation to sell. Regardless of whether the P&L on the screen in front of you is bright green or blood red, we are hardwired to want to be right. Selling a profitable trade delivers the intellectual satisfaction of being right; after all, we were shrewd enough to get in at a lower price than the price at which we sold. We won.
Sitting patiently and allowing a trade to work over time is probably THE SINGLE MOST DIFFICULT SKILL that a market participant can acquire. It is also probably the most valuable skill.
After the 1929 market crash, Livermore was thought to have been worth over $100 million, making him one of the wealthiest people on the planet at the time. In the 1920s, there was no electronic trading. In fact, Livermore had to place his trades over the phone, and very often the person at the other end of the line was receiving delayed quotes from the floor of the New York Stock Exchange. The trade wasn't completed until the guy at the other end of the phone line received a confirmation back from the exchange floor. On busy days this could mean waiting for the confirmation of a fill until the end of the trading day. This considerable 'friction' in terms of placing orders and getting trades executed was probably a strong incentive to trade less and to only pick up the phone when the setups were the strongest.
Today, one hundred years later, it has never been easier to instantly place a trade through a smartphone. There are obviously some huge advantages to having so much power in the palm of one's hand. However, there are also some big negatives to being able to instantly place a trade. Never before have humans been in constant need of entertainment and stimulation. Financial markets offer us the allure of windfall profits and a constant stream of stimulus in the form of volatile stock prices and ever-changing charts.
The problem is that good trading is pretty boring and should follow a structured process. Lightning-fast trade execution in the palm of your hand isn't necessarily a positive thing for many market participants because the temptation to satisfy our urge for stimulation is too strong. We need to develop a system of rules and a process to save ourselves from what is often our worst enemy: ourselves.
When we enter a new trade and the market quickly confirms that we are on the right side, the impulse can often be to sell and take the small profit. However, the strongest trends can begin with a trade quickly showing a profit. Livermore was fond of trades that quickly showed him a profit, and he was not shy to build a bigger position at higher prices.
"Continue with trades that show you a profit, end trades that show a loss."
The reality is that we simply do not know how far the market can rise. In the most prominent examples of stocks that delivered enormous gains (5,000%+), the early bulls could have never guessed just how high these stocks would eventually rise.
To be clear, Livermore greatly preferred to trade in trending market environments and cautioned against trading in range-bound oscillating market environments. His style was to swing a big bat in search of outsized market moves. With no interest in hitting singles, his game was swinging for home runs.
If the market doesn't give you a reason to exit, then why should you exit?
We can always conjure up reasons why selling and taking profits is the right move, but we are inevitably going to cut our profits short and make sub-optimal trading decisions (unless these reasons are rooted in a defined position sizing/risk management methodology, or a strong fundamental/technical consideration).
Tips for riding trends and maximizing profit potential:
- Have a separate trading account for long-term positions that you don't intend to trade often.
- Size positions appropriately relative to the size of your risk capital and overall bankroll. If market volatility is causing you to lose sleep, then you know your positions are too large.
- It's much easier to handle volatility in a position that constitutes 2.5% of your account equity, as opposed to one that constitutes 25% of your account equity.
- Develop a checklist that you follow religiously before placing a trade. This checklist should include questions to ask yourself (i.e. why are you placing this trade? Are you following your plan? Is there emotion involved or is this based on analysis of data?).
- Generate a profit-taking game plan based on chart technicals, not based on your feelings. This could be a system that is as simple as Do not sell until a weekly close below the 200-day simple moving average OR sell 10% of position if Daily-RSI(14) is above 80. If you're concerned you will end up selling at a reaction low, maybe you will develop a system based on the 211-day moving average to be different from the crowd.
Develop a risk management protocol that includes the maximum percentage that a single stock can hold in your portfolio. For me, it is a 10% maximum weighting. When I have bent my rules in the past, it has been an overall negative for my P&L.
We can confirm that in order to reap 1,000%+ gains in the stock market, we are going to have to hold onto positions during uncomfortable moments - can you stay long in the midst of a market correction when other market participants are screaming fire in a crowded theater?
From my experience, it is extremely difficult to not allow oneself to get shaken out during market downturns. And that is precisely why we need to implement a selling discipline, a set of criteria to follow and evaluate before we take action.
Great Bear rose ~10,000% from 2017 to when it was acquired by Kinross Gold in February 2022 at $29 per share. During its five-year ascent from being just another penny stock junior gold explorer to being the most successful gold exploration stock on the planet, Great Bear experienced multiple 40%-50% corrections, including a more than 60% decline in early 2020 during the COVID crash market meltdown.
Great Bear Resources (July 2018 to February 2022)
Simply put, hindsight makes it look like cashing in on Great Bear's spectacular rise was an easy task. However, the reality was a very different story. I can only imagine how many investors were shaken loose at the depths of the March 2020 market meltdown. Suffice to say, the market shook many Great Bear bulls off of their stock before GBR made its final charge higher in the closing months of 2021.
Without a strong selling discipline and a consistent process, the market will do its best to shake you loose from your most profitable winning trades. There is no magic formula for letting profits run; one has to develop a methodology that makes sense to them and have the discipline to implement it.
In the last week, a stock called Aston Bay (TSX-V:BAY) has captured the attention of a tiny corner of the global stock market, the Canadian junior mining sector. I won' t be discussing the potential major copper discovery on an uninhabited island in far northern Canada. However, the story is exciting enough that one of the most well respected analysts in the industry has recently stated:
"There is a huge amount of expansion potential here. This does look like a bona fide new discovery that could be world class. “World class” is a term that promoters throw around a lot. Very few projects actually deserve that moniker. Storm may very well be one of them. " ~ Eric Coffin of HRA Advisory
Will this be a short-lived sugar buzz, like we have witnessed so many times before in junior mining stocks? How high could BAY rise?
These questions are beyond the scope of this blog post, but suffice to say that nobody knows the answers to them at this moment (8:00pm EST 8/8/2023). Since last week's news release detailing the first two holes of this season at Storm, I have taken trading positions in both BAY and its 80% option partner, American West Metals (ASX: AW1). The positions are showing me profits, and I intend to practice the same approach to maximizing the profit potential that I have outlined in this post.
As one of the greatest speculators to ever live once said, 'Continue with trades that show you a profit.' To be continued....
DISCLAIMER: The work included in this article is based on current events, technical charts, company news releases, and the author’s opinions. It may contain errors, and you shouldn’t make any investment decision based solely on what you read here. This publication contains forward-looking statements, including but not limited to comments regarding predictions and projections. Forward-looking statements address future events and conditions and therefore involve inherent risks and uncertainties. Actual results may differ materially from those currently anticipated in such statements. This publication is provided for informational and entertainment purposes only and is not a recommendation to buy or sell any security. Always thoroughly do your own due diligence and talk to a licensed investment adviser prior to making any investment decisions. Junior resource companies can easily lose 100% of their value so read company profiles on www.SEDAR.com for important risk disclosures. It’s your money and your responsibility.