Trading Rule #6 - Profit Stop Exit
By following your entry rules, your portfolio now includes a number of active trades. For these active trades, you have placed stop loss orders based on your money management rules. For the majority of these trades, the trend will not continue, and you will be stopped out with a small, but manageable, loss. A few of your positions, however, have continued to follow the prevailing trend, and you are making money on these positions. The natural reaction when traders see these profits is to sell them and realize the profit. With a trend following trading strategy, you need to resist the urge to sell your profitable positions and let the trade continue so you can capture as much of the trend as possible. You should, however, have a trailing stop that follows your trade up and is always active; so that when the trend eventually ends, you will automatically be stopped out, so you can capture as much profit as possible.
Our goal is to keep our trading strategy as simple as possible. As such, you may want to consider using a similar strategy for your profit stop exit as you used for your stop loss exit. However, once your trade is profitable, you may want to give it a little more wiggle room so you can stay with the trend as long as possible. Remember that about ten percent of your trades will be responsible for the majority of your profits. If you used a percentage stop loss as your original exit, you may want to consider doubling the risk you are willing to take on a profitable trade (i.e., 5% stop loss exit vs. 10% trailing profit stop exit). This would result in you being stopped out once your trending trade declines 10% from the high price of the trend. If you used a 2 x ATR for your stop loss, you may want to consider a 4 x ATR for your profit stop exit. An ATR profit stop exit is also known as a chandelier exit. You should experiment with profit stop exits during you backtesting. Your profit stop exit will replace your stop loss exit once the price of the profit stop exit is greater than the purchase price of the stock. Remember that your stops can only be moved up, never down, and all open positions should always have a stop in place. This removes emotions from your decisions about when to sell.
In the next lesson we will start Backtesting your trading strategy
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