Ask Colin

I am concerned about giving back a lot or all of my profit on good moves because the logical stop-loss is so far away. Any thoughts?

This is a very common experience. We pick a stock and it screams upward with hardly a pause. Or, it marches steadily upward day after day, slowly enough, but without any retracement, of even a few days, which might indicate a higher support level than the one we used for our stop-loss when we bought the stock.

As in most of trading, there is no simple solution. Every answer comes with pros and cons. Nor is there any "right" answer for all circumstances.

When this issue was discussed at a recent ATAA meeting in Sydney, several members put it to me that their trading plan was flexible and that they just adjusted the rules to the circumstances. I personally think this is dangerous, because it approaches the point where they in fact have no trading plan. Our trading plan is our guide to making good decisions under pressure in the market. When we do not know what to do, we should be able to find an answer in your trading plan. If we can't, then our trading plan needs further thought and development.

Against this, there were ATAA members who took the simplistic approach that their plan put the stop where it was and they would simply follow the plan. I think this is better than the first answer, because these people are following their plan, which is a real one. However, I think they may be trying to be blindly disciplined when there may be a better way or ways.

The conundrum of having a plan that is so flexible that it is non-existent versus a too simple rigid plan that does not serve us well, can be resolved by having a plan with rather more sophistication. In other words, a plan needs to have envisaged this situation and we have thought through and written down what our tactics will be. This is different to the kind of flexibility discussed above in that the plan I am talking about was created BEFORE we entered the trade.

As always, the first step is to know what it is we are trying to do. Are we trying to trade these upswings? If so, we need rules for how we will take profits (progressively or at once) as these upswings unfold or show signs of exhaustion.

However, I doubt this is the situation we need to deal with here. Rather, there is a strong desire amongst experienced traders to trade trends and not just the swings within them. The problem is that it is very difficult to sit through the downswings in trends. It is quite galling for most people to suffer complete erosion of their paper profits to an exit at their stop-loss when hanging on to catch a trend that fails.

One type of solution is a half-way house approach. As the trend swing gets extended, take some profits, but let some of the stake continue riding. If the trend then suffers a correction, buy back as soon as it appears that the correction is over. For example, bouncing off a support level (if there is one) or using short term trend analysis and reversal signals. Alternatively, we could wait for a new high in the trend and re-establish our position once this confirmation of the trend is in place.

Arguments against this are the psychological difficulty of buying back into trends, especially new highs and taxation. I think the former is dealt with by thinking through what we are doing - giving up some profit and paying some commissions in order to reduce risk for a while. The second is dealt with by remembering that it is better to pay tax of $1 million than avoid taxation by making a loss.

I am not saying that a given investor might not decide to hold on so they do not have to pay the tax. That is a legitimate choice. However it is a tough one in the situation we are discussing because the loss of profit on the correction is immediate and real in terms of psychological regret, but the tax advantage is unconscious and ephemeral. Maybe investors taking this approach need to make the tax numbers more explicit. It is possible to calculate that if the stop-loss is more than a certain distance away, we would be better off to take the profit and pay the tax.

There are other ways to deal with taxation, including viewing your portfolio in tax-paid terms all the time, so you do not focus on pre-tax profits. Another might be to look at two figures when you review your portfolio - the paper profit and the amount of capital you would lose to taxation if you take the profits.

Another solution might be the one you suggested to me in discussion. That is to hold on to the positions, but hedge them using warrants. Options or futures are also possible. Warrants and options will be like an insurance policy - you lock in your selling price, but at the cost of a premium or part of a premium. Futures are more complex and a true hedge in the sense that your gain on the futures will offset the loss on the portfolio (not exactly of course and that can be a problem if your portfolio is very different to the index in its movements or if you only want to hedge one stock).

Derivatives are also dangerous instruments in the hands of beginners, who should take competent advice before acting.

Using derivatives should never be a process where selling is postponed when the trading plan says that the trade or investment is not working.

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