Lesson 38 – Why Trader’s Cut Profits Too Soon

Topic Progress:


In the previous lesson we looked at how many traders use technical indicators as an additional factor they consider when deciding when to exit a trade. In this lesson we are going to begin to move into the next phase of our series on money management strategies, with a look at how traders go about taking profits once a position moves in their favor and some of the difficulties that are associated with this. Before getting into the details of what a trailing stop is and how many traders incorporate this into their stock futures or forex trading strategy, it is first important to understand the trading psychology behind taking profits.

From the last several lessons you should now have a good understanding of some of the psychological difficulties people have in taking losses, and some of the different money management strategies that can be put into place to help overcome these difficulties that are the downfall of so many traders.

What may come as a surprise to many of you is that just as many traders have problems letting their profits run as they do in cutting their losses. To help illustrate this I am going to give a quote from one of my favorite books on money management strategies Trade Your Way to Financial Freedom by Dr. Van K. Tharp. When explaining this concept in his book he gives the example below:

When given a chance for “1. a sure $9000 gain or 2. a 95% chance of a $10,000 gain plus a 5% chance of no gain at all….which would you choose?”

A study which was done on this showed that 80% of the population chose the sure thing even though the second opportunity represents a $500 larger gain on average.

Similar to the way that human’s are raised in a way that does not allow them to accept losses our environment also teaches us to seize opportunities quickly, or “that a bird in the hand is worth two in the bush”, a rule that goes against the second half of the most important rule of trading:

“Cut Your Losses and Let Your Profits Run”

With this in mind we can now move into the next phase of our series of money management strategies with a look at some of the different ways that traders go about managing their position once it begins to move in their favor starting with a look at trailing stops.

Once a position has begun to move in a traders favor, many traders will implement a trailing stop which is basically a strategy for moving the stop they have implemented on their position up when they are long or down when they are short to lesson the loss or increase the amount of profit they will take should the market reverse and begin to move in the opposite direction of their position.

As you may realize from watching my previous lessons we have already gone over one precise method which many traders use for setting trailing stops, the Parabolic SAR. In the next lesson we are going to go over several other methods, so we hope to see you in that lesson.