Investor psychology is an integral part of trading. The importance of taking profits after a big score or of cutting your losses before they really get out of hand cannot be understated. It is almost inevitable that traders will obtain some degree of emotional attachment to their investments.
The problem with this reality is that it can lead to a trader holding onto a stock when a technical or fundamental analysis no longer warrants holding it. Fortunately there are various strategies that traders can utilize as safety nets to avoid falling into one of these traps. Three such strategies that traders can consider are percentage profit targets, trailing stop orders and swing rule type targets.
Percentage Profit Targets
A percentage profit target is a straightforward way for a trader to set a price target at which their position will automatically be closed. The benefit to this strategy is that it sets forward a rational approach to locking in profits as opposed to letting irrational speculation takeover when things end up going better than expected.
For instance, suppose a trader was to buy shares of Apache (APA | news | PowerRating | PR Charts ) and was of the mindset that the prices of natural gas stocks were going higher. Let us further assume that the trader purchased shares at $100 and held the belief that shares had 20% of upside before a sharp correction might occur. To carryout this strategy, the trader would enter a sell limit order for $120 after the shares were purchased at $100. Now if shares were to rise to $120, the order would automatically execute and the trader would lock in a 20% gain.
Trailing Stops
Although it is a little bit more complex than a percentage profit target, a trailing stop order is an effective way for a trader to exit a position that is heading in the wrong direction. It can also help to lock in profits. It is a stop order in which the stop price is set at a fixed percentage or dollar amount above or below the market price of a stock. If the stock price rises, the stop price rises proportionately, but if the stock price falls, the stop loss price does not change.
A trailing stop is set at an amount below the market price for a long position. It is set at an amount above the current market price in the instance of a short position. The amount is automatically adjusted as the price of the stock changes. It allows traders to remain in a long position that continues to appreciate, but exit the position when the price drops a set amount. In the case of a short position, it is utilized to allow a trader to remain in a short position where a stock continues to decrease in price, but the position is closed once the stock rises above a set amount.
An example of a trailing stop order would be a trader entering a trailing stop of 15% after purchasing shares of Apple (AAPL | news | PowerRating | PR Charts ) at $150. In a worst case scenario if shares of Apple were to go straight down, the order would cause shares to be sold at $127.50, or a 15% loss.
However, let us assume that share were to rise to $200. The trailing stop would now adjust to cause shares to sell only if the price of Apple shares were to subsequently drop to $170, or a 15% decrease from $200. Because the order automatically executes, a trailing stop eliminates the emotional aspect to trading. And because it adjusts automatically, it protects traders from giving back all of their profits in times of a pullback following a sharp rise in the price of a stock.
Swing Rule Targets
A third type of strategy that I will touch on briefly is the utilization of swing rule type targets. Swing rule type targets encompass targeting used by traders with movements in stocks such as double bottoms and head and shoulders tops.
A head and shoulders top is a pattern that forms as a stock encounters three consecutive rallies which form sharp peaks that result in a chart which resembles a human head at the highest point and shoulders on each side. The formation of or a drop below the final shoulder in this pattern can signify that it is time to sell the stock or take a short position in the stock. If such a pattern is suspected, a trader can set a sell limit order where the right shoulder is to form in order to exit one's position.
The double bottom is a reversal of a downward trend in a stock's price. It can be a prime buying opportunity for traders as the double bottom often marks the beginning of a stock's newly found uptrend. If you look at a one year chart of the iShares Dow Jones U.S. Aerospace & Defense ETF (ITA | news | PowerRating | PR Charts ), you would see the double bottom pattern that forms as the stock rapidly declines in January and then subsequently completes the double bottom around March 10.
An advantage to swing rule type targets is that they visually depict reliable patterns that can help a trader decide when to buy or sell a stock as opposed to relying on raw emotion.
There are many strategies that traders can employ to guard against becoming emotionally attached to one's holdings. Percentage profit targets, trailing stop orders and swing rule type targets are just three of these strategies that traders can use to help lock in profits. Under the right circumstances, these strategies can be extremely effective for traders to unleash from their arsenal.
Billy Fisher is a CPA and a freelance investment writer whose work has appeared in Investor's Business Daily, TheStreet.com and SmallCapInvestor.com. He holds a master's degree in accounting from the University of Notre Dame and a bachelor's degree in accounting from Canisius College.
