Ask Colin

What do you do if you have a small profit in front of you and there is the possibility or a larger one?

This is a very important question. It is absolutely basic to the whole idea of trading.

If there is one guideline that should always be top-of-mind for every trader it is to cut losses short and let profits run.

So, the quick and dirty answer to your question is to let the profit build. Let it run.

The idea behind this is that if you pick the direction of a stock correctly around half the time, cut losses short and let profits run, then your average profits should be larger than your average losses. You should do OK and could with good fortune and enough capital become quite rich.

Most trades should result in small losses or small gains. Over time they should roughly cancel out at worst, but put you in front in a bull market. However, there are then some outliers at the extremes of the bell curve. Remember the Pareto principle or 80:20 rule. 20% of trades make 80% of the profits. But there is another 20% which make 80% of the losses. The aim of the game is to cut off the 20% of losses that are large, while letting the 20% of profits grow as far as possible.

That is simple isn’t it?

Simple it is, but easy it isn’t. What it requires is a discipline that is exactly opposite to your natural impulse, which is to grab profits quickly before they get away from you, but let losses run in the hope they turn back into a break-even situation. This is what almost all losing traders do. 

So, in the situation you describe, you should do two things. First, you make sure that you know where your sell-stop is so that if it goes wrong, the loss is small. Notice I put the sell-stop requirement first. The first aim is not to lose big. Second, you let the profit run and move your sell-stop up as your method allows, which will lock in profits if the trend fails.

The problem with this is that the bigger the profit that builds, the more difficult it is to hang in there allowing it to build and build. Indeed, I don’t believe it is smart to just let it get too big. This is especially true if the profit becomes many times your initial investment and the price starts to rise almost straight up into greater fool territory.

It sounds contradictory, but my policy is to take some profits progressively. My plan is to sell half of my position every time the price doubles. This works because it is better to let half of your position keep growing than to have taken it all off prematurely. Suppose you get on to a ten-bagger. You invest $5,000. It doubles to $10,000 and you take the profit and take your mates out for dinner to celebrate. Good. But how will you feel when it keeps rising – eventually, to $50,000 without you? Not good, I suspect.

So the way I do it is to put in the $5,000. When it gets to $10,000, I take out $5,000. Then every time it gets to $10,000 again, I take out another $5,000. Now you will feel better.

Of course, if you just left it all there you would have made more. Or would you? Could you have left it there? It takes a lot of intestinal fortitude. My experience has been that most of us are more likely to stay with a great trade if we take profits progressively and keep the growing position underneath our sleeping point.