This is a simple enough rule that everybody applies without thinking about. When a floor trader first told me about it I dismissed him as being overly cautious. I continued to make the mistake of selling out my winners and keeping my losers. As a young trader, my mistakes could be overcome; as I get older, the mistakes are more difficult to overcome.
Let's go through the process of placing a trade to illustrate how I manage to maintain a profit in it. When I make a decision to buy or sell a futures or a stock, I also figure out how much I am willing to risk on the trade.
Let's say I want to buy 100 shares of IBM at $124 per share. I figure out that I will put in a stop order at around the $121 level. The actual number is something like $120-7/8. Whole numbers and even fractions are where the public enters the markets; I stay away from public orders.
There might be a lot of public orders resting at $121 to buy the stock, but all the orders to buy at that price won't be filled. If they are all filled at $121, there's a reason why informed insiders would be willing to sell all the public wants to buy at the $121 level. My selling out my position at $120-7/8 would be warranted because the price of the stock should drop pretty drastically after all the public orders to buy at the 121 support level are taken out.
Let's go back to the original scenario, where I buy stock at $124. I now enter an order to stop out my position at $ 120-7/8. At $120-7/8 I am taking a $3-1/8 risk. If the price does not drop to my stop price, then I must wait patiently for it to go up. The rule that cautions me not to let a profit turn into a loss tells me that once the price of the stock goes above my purchase price I must get rid of it if and when it starts to show a possibility of a loss.
(The rule does not tell me to get out of a winning position if it shows a profit!). If the price reaches a high of $124-1/8, I must be willing to let it go at $124 if it ever dips back there. At $ 124-1/4 I must sell it if it gets back to $124. If it shoots up immediately to $130, I must sell it if it gets back to $124!
However, strict adherence to the rule is impractical for two reasons. The first reason is that markets never go straight up or down. If you bought a stock at $124, you can't realistically expect it to go straight up without any backing action. The second reason is that the cost of commissions to the outsider is too high relative to the minimum fluctuations. If commission costs are $50 for a one-sided execution on a 100-share trade at $124, the stock price would have to go up to $125 before you would break even. If you got out of the trade at the same price you went in, you would wind up a loser.
In this example I used a trailing $3-1/8 point stop, or whatever dollar amount I was willing to risk on that type of trade. That is, if the stock trades up to a high price of $125, I would move my stop up to $121-7/8, risking $3-1/8. If the stock trades up to $126, I would move my stop up to $122-7/8, still risking 3-1/8.
The subjective judgment comes in once the stock trades at or above $125. Here I would risk a potential loss of $2-1/8 from my original entry position of $124; at $126 I would risk a potential loss of $1-1/8 from my original entry position of $124. I am making a distinction between potential losses from entry price and the potential loss from the high move. The first case is oriented towards trading equity, independent of market action.
In the second case, the profit valuation is based on trading equity plus a portion of the paper profits dependent on the high of the market's up move. My main objective is to preserve my initial equity. If I can maintain control of my equity, I will have greater control over market risks to my paper profits.
In either case -- a $125 high or a $126 high -- I would risk losing part of my equity. According to Rule 4, any deterioration of trading equity is not acceptable, so with the entry price at $124, my exit point must be at $124 if the trade goes against me. The problem concerns the definition of a loss. At what price level or time span, relative to the entry level of my trade, do I have a loss?
When you put on a trade, the potential loss must be taken out of your trading capital. If you buy stock at $124, you place a stop at a lower price. The difference between the entry price and the stop loss price is your potential loss.
When the trade you have put on starts to show a profit, at what point do you consider the paper profits a part of your trading capital that you can use to gauge potential losses? If the stock you bought at $124 is now at $130 and you still have the open position, you now have a paper profit of $6; on 100 shares of stock you show a profit of $600. At what point do you consider this $600, unrealized as it is, to be part of your trading capital?
This is hard to determine, and since you are dealing with capital, it isn't a question of mere semantics. If you consider your trading capital to be original capital less the paper profit, then you can let the price of the stock dip all the way back to $124 before you start to worry about a deterioration of your trading capital.
If, on the other hand, you consider the $600 paper profit to be part of your trading equity, then once the price dips below $130, you will have sustained a loss. I settle on something in the middle when the price appreciates to a level where my position cannot be taken out at a loss if the trailing stop order is executed -- I take half of the paper profits, as marked by the extreme of the move and use that as a stop point, give or take a few fractions. That is, with the initial entry price of $124 and a high swing of $130, I would place my stop at around the halfway mark -- somewhere slightly below $127: $ 126-7/8 or $ 126-3/8. This is a rule of thumb to preserve some sort of profits. The actual stop price might be closer to the lower range of some important chart support point.
I have always chosen the halfway mark as a balance. At a one-half retracement back, you have an even chance of being wrong or right. A one-third retracement back would be giving the market too little leeway in reactions. The market often retraces one-third, only to resume its original direction. If you unload your position at a one-third retracement, you would be selling prematurely out of a bullish move. On the other hand, a two-thirds retracement would be offering the market too much of your profits. I have often found that if the market backs two-thirds, it is too weak to rally much. If this situation occurs, then it is a good idea to close out your positions.
Whatever frame of reference you use to determine whether market retracements have affected your profits, you must do it systematically. You can't consider a dip below the high of the swing to be a loss of profits on one trade and a dip to the halfway mark of your paper profits to be an erosion of profits on the next trade.
A systematic approach to valuing market losses is crucial in evaluating future market trends. The permutations of the markets are infinite and random, whereas the methods of analyzing the markets are finite and must be systematic. Your goal as a successful trader must be to make the market less random and less infinite.
Excerpt from Stock Market Trading Rules: 50 Golden Strategies by William F Eng.