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Part 8 excerpted from lesson 10.2 of the upcoming Trade Like a Pro ver. 10 course.
Professionals know that profits can disappear for many reasons, and they therefore take profits early. Unlike the buy and hope investing, Professionals want to capture only the profitable side of standard deviation. They take profits early and often. Why do the best endowments and hedge-funds far exceed the returns of everyone else? They avoid losses by taking profits.
I was lucky to have a client, who we will call “K”, who believed as I did in the power of experimentation. We set aside several hundred thousand dollars, in a separate account, from his vast portfolio and tested trading ideas. Today it is easy to use software to paper trade live markets but not so in the early ‘80s and ‘90s. Much of what we later implemented across all portfolios first proved successful in this account. The importance of targets became a strong lesson. We tested a net neutral portfolio, where half the assets were long and half the assets were short. The theory being if you buy the best and sell the worst, you should outperform. A portfolio like this is most profitable, but requires the trader to master cognitive dissonance and follow the rules.
The short side of the portfolio relied on fundamentals to identify overvalued securities. It was here that I learned the lesson about the fatal flaw of fundamentals. Something can remain overvalued for an extended time. Several trades became profitable only to reverse and wipe out the profits. Professional traders know that profits can be temporary and disappear in the wind due to many outside causes. So Professionals take profits when they have them. Once we added structural targets based on risk to the portfolios, we eliminated the reversal losses.
Targets are not based on profit potential, but rather on perceived and actual risk. Professionals determine risk at the beginning of the trade and their first goal is to get the trade to a risk-free state as soon as possible. An initial target captures the profit that protects the rest of the trade from loss.
Professionals use the Traders Equation, discussed earlier, to accomplish this:
“The probability of a trade reaching its profit target before hitting its protective stop is greater than the probability of the market hitting its stop before reaching its target.”
This initial target often confuses buy and hope investors. Just as the stock starts to breakout into a bullish move it reverses. Despite the fact that the bulls may be in control and will continue to drive the market up, an early sell-off occurs. This often occurs where the conservative investor has enough confirmation to enter. The late entry experiences an early loss before the market continues a bullish move, yet not because the bears overwhelmed or pushed back against the bullish tide. It happens because the bulls take their first target. The bulls and bears are selling together. But it only lasts for a moment before the trend continues. Then it happens again, and again. At each point the Professionals are taking targets then re-entering lower in the pullback.
Why does this occur? It allows the Professionals to get paid twice to cover the same territory. So if the market rose ten percent, they made twelve to sixteen percent in the same move. The point we need to consider is, if Professionals believe it is important to take an early target to reduce risk, so should we.
The initial target is based on the risk, and so are all other targets. The further we move away from the entry, the more structure adjusts the location of targets. Here is where the significant gap in performance between Professionals and non-professionals increases. The ability to manage the trade with simple rules pays off, and the gap widens.
The Six Keys of a Risk Control System
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