Earlier we talked about how exiting a position is tougher than entering a position. We also concluded that it is important to bring to bear all one's skills and judgment into taking a position. You can follow this link to our earlier article if you want to read this in perspective.
A quick recap
Just in case you want to get on with it pronto, here's a...what else, quick recap.
Basically, we said that before entering a trade, you must explore the choices, take your time. You must be sure to do it on your own terms. Make sure the trade has enough profit potential. Also, make sure the downside (as defined by the stop loss level) is a drain your wallet can weather easily. And returns are to be seen only in the context of the downside. You should not look at a trade unless you stand to make at least 2.5 times the amount you are willing to lose. If a trade does not fit these parameters, forget it. Look for the next one. There is a profitable trade born every second.
The more careful you are about taking a position, the easier it will be for you to exit the trade. In the final analysis, a trade is exited only for two reasons. To take a profit or to stop a loss.
Profits? Aaaarghh...
Since we are all eternal optimists, let's share our insights into what should be the most pleasurable of all trading activities. Taking profits. But is it really pleasurable? Read on.
The familiar adage is "Cut your losses, let your profits run". Sounds simple doesn't it. And totally logical too. But believe you me, this is probably the most difficult of all trading strategies to implement.
How many times were you faced with a situation where the stock goes on to double from the point at which you sold it? What stopped you from riding the stock all the way? Why is it so difficult to sell at or close to the top?
The most obvious reasons are fear and greed. Both these reasons work in combination, one moving in when the other fades out. This is how the fear-greed cycle works.
Fear comes...
After a trade is made, there is fear to begin with. Fear of losing the profits that the market has graciously allowed you make. Fear, emerging from the lack of total conviction in the trade. Fear, fed by conflicting market information, rumours and opinions.
These fears push you toward booking profits early. You rationalize the whole thing by saying that cash in hand is worth twenty times the amount available in the market. "With the market being so fickle, better to get out while we are ahead. So let's book", you tell yourself. After all, as the saying goes, "No one made a loss by booking profits".
..to be replaced by confidence...
Let us assume you were able to overcome these fears and hang on to a position. As you watch profits grow, so does your confidence in the trade. The very influences that gave you cause for worry earlier seem to matter even less. Confidence soon gives way to over-confidence. You start to strut. You start to brag. Totally understandable, since you can't ever do that when you make losses. Unless you are lying. Which is also totally understandable. After all who wants to admit to losses. We do, for one but that is a totally different issue.
...which also is short lived
Getting back to your trade, you find that the price is starting to top out. It struggles to hold on to its highs. Everyday it slips a little. You are watching, but aren't overly concerned. You are still sitting on a good profit, right ? So what if it is unrealized. You just have to sell, and all that money is yours!
You think this is just a correction and the stock will begin to rally soon. Then suddenly there is a big sell-off and the stock is at the lower circuit (aka limit down). You are shaken. You decide enough is enough, and at that point mentally resolve to sell on the next bounce. But the price continues to slip lower. (In this context a rapid sell off is better in making you react than a gentle gradual drop in prices. This kind of price action lulls you into believing nothing serious is afoot.)
Fear, our old friend, comes back for a visit
As prices continue to fall and your unrealized profits continue to shrink, the fear comes back again. The much-anticipated bounce back just doesn't come. But you are still waiting for it. A new fear sets in. Fear that the market will reverse all the profits and leave you holding a loss-making position sets in. If you are disciplined enough, you sell and get out of the trade. But for most people the fact that they missed the opportunity of taking much larger profits gnaws at the insides.
They continue to hold. They are almost frozen into inactivity by this fear. They wring their hands in dismay and lose sleep over their position but they find that they just can't get out there and sell. They find themselves incapable of reacting to the erosion of their dreams. If you are lucky you will grit your teeth and sell at a small loss.
...and stays
You could have booked your profits at any point. But would you have been totally happy? Either you would wish you had made a little more as the price continued to rise after you sold. Or you would wish that you not missed the sitting duck opportunity to make a little more by selling earlier. Either way it is your emotions that make profit-taking a less than perfect joy.
Next time, we will look at how to purge these emotions from the profit booking process. We'll discuss some techniques that will allow you to make the most of a profitable trade without letting your emotions get in the way.
May the Gods of the market bless you with profitable trades!
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