Why are traders taking profit too early? It is first important to understand some of the psychology behind this question. What may come as a surprise to many of you is that many traders have problems letting their profits run. They also have problems cutting their losses quickly. To help illustrate this point I’m going to quote an example that Dr Van. K Tharp gives in his book, Trade Your Way To Financial Freedom.
In this book, Dr Tharp points to a study in which people have the chance for either:
With option 2, there is the opposing 5% chance of $0 going into their bank account. The study concludes that 80% of the population chose the guaranteed $9,000. Even though the second option of a 95% chance of $10,000 represents the opportunity to reap $500 more on average. This is because 100% of $9,000 is $9,000 and 95% of $10,000 is $9,500.
This example illustrates some of the psychology behind why many traders fail. It relates to taking profits off the table too quickly. Traders are often not willing to give up some of those profits. Psychology demonstrates that our environment teaches us to minimise loss and to take opportunities quickly. This really goes against the number one rule of trading, which is to cut your losses quickly and let your profits run.
With this in mind, we can look at a number of strategies that traders use to overcome some of these psychological difficulties to make sure they let their profits run.
A popular way of doing this is to use a trailing stop. In very simple terms this is a way that traders move their stop up if they’re long in a position that begins to move in their favour. Conversely, it will move their stop down if they are short in a position and that position moves in their favour. This will further limit the amount of loss that they’re going to take on that position. Especially if the market reverses direction. Or lock in some of the profits if they are already in the in the black on that trade.
There are several methods which you could use to place trailing stops and one example is the parabolic SAR. In an upcoming lesson, we will look at specific strategies which you can use to help lock in profits and overcome some of the psychological difficulties to put yourself in the successful percentage of traders.