Dealing with profit erosion

Today was an interesting day. My one existing long position saw its profit evaporate after the release of a trading update, after which the stock fell just over 7%. However, this drop did not invalidate the trend, nor did it hit my stop. As a result I continue to hold the position. Of course, that may change tomorrow...

Dealing with this type of price action formed part of the discussion in our trading group today. Price moves like this can and do happen, in the same manner that price moves following trading updates or earnings reports can go in your favour. 

Markets have an uncanny ability to find and test your weak point.

In a situation like this, the big danger is that someone overrides their rules, and closes a trade banking a small profit, based on nothing more than a fear of losing it. That is the worst thing a trader can do. 

In terms of R, the open profit on this particular trade on today's open equated to approximately +1.5R, so it was not a huge profit in the overall scheme of things. Richard Dennis talked about the Turtles having to accept seeing profits turning into losses. Dealing with profit erosion, and being able to accept it, is part of a successful trend followers' make up.

If you've taken the time and effort to construct your own rules, which are proven and give you a positive expectancy, then why would you override them? To me that's a waste of your time.

Very, very occasionally, someone may override their rules in this manner and end up getting out at the top of a move. this makes them feel smart. That may work one time in a hundred. Over the long haul, sticking to your rules will generate far more in profits than trying to be smart or clever.

As a trend follower, accept that you will NEVER get out at the extreme of a price move - price has to move against you a certain amount (which your own rules will determine) before an exit signal is given. And that will be true whether you use price channels (like I do), moving averages, or any other method. If you don't do this, and try and anticipate the end of a price move, who is to say that you are simply overreacting to a minor retracement or 'noise'?

There is also the possibility that you will end up cutting your winning trades short. Think back to the big move downwards in crude oil last year, which started north of $100. No doubt you would have felt great pocketing your profits when price fell to say $90. The problem was that price carried on falling without you, down to the $50 area.

Typically with a trend following approach, your win rate is less than 50% - mine is only around 1 in 3. So, to generate an overall positive expectancy, I have to have winning trades that are much bigger than all the small losses I take. And the only way I can do that is by letting the winning trades run as far as they can - if I didn't, and cut those winners short, then the positive expectancy would be destroyed.

Here are the words of Jesse Livermore on this issue:

"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I've known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine--that is, they made no real money out of it. Men who can both be right and sit tight are uncommon."

"Old man Partridge's insistence on the vital importance of being continuously bullish in a bull market doubtless made my mind dwell on the need above all other things of determining the kind of market a man is trading in. I began to realize that the big money must necessarily be in the big swing. Whatever might seem to give a big swing, initial impulse, the fact is that its continuance is not the result of manipulation by pools or artifice by financiers, but depends upon basic conditions. And no matter who opposes it, the swing must inevitably run as far and as fast and as long as the impelling forces determine."