Account Management
What, When to Trade
Taking Profits

Making the Trade

Each online broker is different, but they usually have similar order types, which are:

• Market order. This is when you place an order to buy or sell at the current market price. Essentially, a market order accepts the ask price at the moment a buy order is executed, or the bid price when your sell order is executed. Remember that all stocks have two price quotes at any given moment: a bid and an ask; a market order merely executes at those prices, whatever they may be.
  
  
• Limit order. This is when you place a buy or sell order at a specified price. On the buy side, your broker will only execute the order if it can be bought at the price you specify, and not a penny higher. On the sell side, your broker will only execute the order if it can be sold at the price you specify, and not a penny less.
  
  
• Stop order. There are two types of stop orders, although they might be called by different names between brokers. One is a stop order (sometimes referred to as a stop market order), and the other is a stop limit order. A stop order is sometimes called a stop loss, because it is mainly used to limit your losses. In a sense, a stop order is the opposite of a limit order, because a stop (sell) order executes if the price falls down to the price you have specified, while a limit (sell) order executes if the price goes up to your specified price. The difference between stop and stop limit is that a stop will execute at the market price, while stop limit executes it no lower than the price you have specified. Stop orders are discussed in more detail later in this section.

Market Versus Limit

One aspect of trading that newcomers often struggle with is when to place a market order versus a limit order, and this subject deserves some discussion. Although there are some exceptions, the basic rule of thumb is the following.

Use a market order when you have a compelling reason to execute the trade immediately. Otherwise, use a limit order.

The only real difference between a market and a limit order is that a market order is nearly guaranteed to be executed immediately. The downside to this is that you may not get the optimum price, and under certain circumstances, the price might deviate substantially from what you were expecting.

For instance, let's say that you want to buy 300 shares of a stock that shows the following quote at the time you place a market order.

According to the quote, you would expect to buy the stock at the market price of $17.30, or the current "ask" price. To your surprise, your order executes 100 shares at $17.30, and 200 more at $17.60. What just happened?

In this case, there were only 100 shares for sale at $17.30, which your order executed. But since you specified a market order, the next price up the "ask" list is $17.60, and it was promptly executed. Had you placed a limit order for $17.30, your order would have been partially filled at $17.30, but you would not have been "forced" to buy any more at a higher price. The worst that would happen is that you would have only bought 100 shares instead of 300, but you would have bought them at the price you specified.

So, why wouldn't you always use a limit order to avoid executing a trade at an undesirable price? The answer is urgency, which is the only time you should really use a market order.

For example, suppose you enter a trade for a fairly large amount of shares, and for some reason, the trade turns against you and the stock is heading south. If you try to get out of the trade with a limit order, it might never execute, or only partially execute, and you could end up getting stuck with deeper losses than you are willing to absorb. In this case, it is probably wise to jettison the trade with a market order, because it may be better to get out relatively unscathed, even at undesirable prices, rather than risk losing crippling amounts "waiting" for some specified price.

On the buy side, the one situation where I will use a market order is when the stock is soaring rapidly off of a sharp bounce (on an AM gap-down, for instance), and it is doubtful that a limit order could get filled. Although limit orders are the "safer" way to go, if there is a compelling reason to execute a buy order ASAP, then market orders are the way to go.

In all other non-urgent cases, always use a limit order.

Limit Orders at Bid and Ask

Some people have the idea that a limit order is used only to get a different, or "better" price than where a market order would execute. This is not the case at all, and in fact, I will often place a limit order right at the same price that I would get if it were a market order.

The reason you want to do this is simply to guarantee that your price doesn't "slip." The above example of buying a stock at the "ask" price of $17.30 is a good example. While you might get the same price of $17.30 with a market order, using a limit order guarantees that you will buy the stock at $17.30 and not a penny higher. True, your full order might not execute as fast as a market order, but that is the whole point—you only go for market when you must get in or out immediately.

Systematic and Consistent Approach

By systematic and consistent approach means that you apply the same strategies and financial disciplines consistently, each and every day. While this may seem obvious at first, you would be surprised how many traders make life miserable by changing the rules as they go.

For instance, an enthusiastic, opportunistic beginner decides to make a large trade on a trade that looks almost certain, and in fact, the confidence level is such that the trader's entire stake is placed on this one trade. Unfortunately, it heads south and loses 2%, but the trader (correctly) bails out before the losses run too steeply. The next trade, equally enticing, is also made with 100% of the stake, and it basically breaks even (with a tiny loss due to broker commissions), for a 0.1% loss.

The next day, this trader thinks things over and decides that placing the whole stake on a single trade involves too much risk, so the next trade is made with only 25% of the stake. This time, the trade goes well, and the trade cashes in a whopping 5% gain in less than 10 minutes.

At first glance, it appears that this trader has been very successful. After all, the early record is one loser, one almost-break-even, and one 5% winner. But I can tell you from experience that this type of pattern will result in financial disaster. Why is that?

This ambitious trader committed one of the cardinal sins, which is inconsistent allocations. Sure, the third trade was a winner, but it was only 1/4 of the total stake! If you look at this carefully, you can see what is wrong with this picture. Assuming that the trading stake was $10,000, consider the following two results—the first being the result of trading 100% for two trades, then trading 25% for the third, and the other trading 100% for all three trades.

You can immediately see the difference between inconsistent versus consistent trading allocations. Under both scenarios, the same trades were made, yet the second scenario made a $290 profit, while the first one lost $85. The point is not that the trader should have necessarily placed 100% of his or her stake on every trade, but rather that the traded amounts should have remained consistent (the same, proportional results would have been obtained had the trader used, say, 50% of the stake for every trade, or 80% on each one, etc.).

A common trap that a trader can fall into is to become influenced by the "certainty" of the trade. Using the above example, it would not have been that unusual for this trader to lighten up on the third trade because it was "not as sure as the first two." You have to fight that temptation at all costs, and remember rule #1 about trade allocations:

There is no such thing as a trade that is more "certain" than any other trade. You must assume that each trade has exactly the same chance of success as any other trade, and make consistent allocations accordingly.

Another common error is to "back off" on one's allocation size because the market appears to be poor, or because one is on a losing streak, etc. This is equally as foolish, because you really can't second-guess such things. If nothing else, if trading conditions are poor, then don't trade at all, or make less trades, or perhaps cut your losses more quickly than you normally would. But do not deviate from your standard allocation, ever.

Even if one trade is technically more certain than others, you must still assume the same principle, because neither you, nor I, nor anyone else is smart enough to every really know. Consistency is your friend; inconsistency is your enemy. Don't ever change your allocation based on a "sure thing" or any other such consideration!

Stop Orders

A stop order is used mostly to stop losses from worsening. Most brokers offer at least two variations of the stop order, one is called a stop order (or sometimes stop market), and the other is called stop limit. Both stop orders require that you specify the price at which you want to sell your shares. The difference between these two is that a regular stop order will sell at the market price, once the stock hits your specified level, while a stop limit sells at your price and only at your price.

As a rule, you should never use stop limit, because if the stock has hit your bailout level at all, it will behoove you to get out ASAP. For this, you want to sell at the market price, because if you set a stop limit, you might not get your stop order filled at all, and you could suffer far greater losses than you anticipated.

Stop Levels

The rule for where to set your stop is simple:

Never lose more than 4% to 7% on any one trade, ever.

In bad markets or otherwise risky trades, you should cut your losses even sooner (around 2%).

The reason it is so imperative that you cut your losses between 2% and 7% is because you will only win on a little more than half of your trades. Assuming that you make 2 to 5% on winners, then you won't ever pull ahead unless you cut your losses short.

There are two ways to limit your losses: either with an actual stop order, or to apply the discipline to do a "mental" stop.

Physical versus Mental Stops

Many traders firmly believe that setting a stop order through your broker "tips your hand" to other traders, and can affect you adversely. What they mean by this is that a sell order through your broker will cause your shares to be posted for everyone else to see, and if an unscrupulous market maker can "walk" the price down on the stock, somehow or another, and take you out by picking up the cheap shares (a market maker is a person or a firm in charge of matching buyers and sellers on the exchange).

Personally, I believe this rarely happens, if at all. But I do believe that this fear comes from the fact that it can look like the stock has been manipulated to "take you out". All it takes is one large sell order from someone, at market price, to take you and everyone else out in one fell swoop, and this creates the illusion that you have "tipped your hand" and let other traders exploit your situation.

For instance, suppose you place a stop order with your broker at $19.98 (which means that you are unwilling to let your trade slip any lower than that price). Unbeknownst to you, the current "bid" prices for a stock appear on the exchange as follows (with your order showing in bold).

• If you are able to keep your eye on your trade at every moment, use a mental stop. This is basically what it implies—you watch the price, and if it reaches a level where it is time to jettison the trade, you sell the stock with a market order.
  
  
• If you will be away from your computer, or if you won't be keeping an eye on your stock every moment, place a physical (real) stop order. Always use a regular stop, never a stop limit order.

Mental Stops

One caution about mental stop orders, however, and that is they require more self-discipline than you might imagine. "Hope" is inherently present in almost all human endeavors, and trading is no exception. If you rely exclusively on mental stops, you may find "hope" getting the better of you, and you change your mind and let the stock sink lower than where you would have liked to sell. Even worse, after the trade is showing a substantial loss, the temptation will be to hold on even longer for a turnaround, because the stock is now so low that you "can't sell now!". This results in a suicide play, and you have to avoid such inappropriate trading at all costs.

Hence, if you use mental stops, it is absolutely imperative that you (a) Choose the stop price beforehand, and (b) Stick to your stop, come hell or high water.

Taking Profits

One of the most difficult aspects to trading is knowing when to sell. While most beginners learn quickly when to cut losses, or even when to buy into a trade, it is usually more difficult to know when to take your gains on a winning trade.

Unfortunately, there is no fixed (or "scientific") formula for this, such as "take gains when they reach 3%" or "take gains when you have hit your price target," because I have found that none of these methods work. Each trade is different, all situations are not the same, and the market itself changes its patterns from day to day.

For instance, on some days, the market loves to produce double-digit winners of 15%, 20% or more. On other days, you are lucky to scrap for 1% on anything. So you will quickly learn that you can use neither price targets, nor percent thresholds, nor any other rigid system to take profits.

Instead, the solution is to recognize the primary reason why it is so difficult to take the gains in the first place.

Demons Within

The main problem with selling a winning trade is that most people struggle with demons within. These are your classic emotions that are, unfortunately, inherent with most financial matters in life, especially trading. Various factors hinder sound judgment about taking profits, namely:

• Hope. It is human nature to hope for more and more gains, so one is often unwilling to take acceptable gains that are presented to them. A cousin to this emotion is one of gambling, or "letting it ride" for more. If this aspect is out of control, you can throw away many otherwise decent profits.
  
  
• Greed. It is also human nature to want higher returns than you are getting, even when they are already excellent. You must control this emotion, or you will throw away some good wins.
  
  
• Fear. This is the opposite of the other two (above), as this emotion will make you sell too soon, denying yourself the gains you should have had. This is when you sell at tiny gains out of fear that the stock will turn tail and you will lose your hard-fought, yet minuscule profits. Somewhere between this and the other extremes (greed and hope) there is a happy medium that you will have to learn.
  
  
• Denial. It is not uncommon to be in "denial" when an otherwise profitable trade starts going south. The other two factors (above) play into this, as one hopes the stock will "come back," and the greed that makes you want more than the current gains. What usually happens is that an otherwise profitable position gives back all of its gains, and then some, and you will end up kicking yourself for no reason. If a profitable trade starts turning on you, take the gains!

As if these demons were not enough, it doesn't help if you sell for a pretty good return, only to watch the stock take off and soar into the clouds. For whatever reason, this will often occur, and it does nothing but fuel the demons of hope and greed. Your best bet is to ignore it, be happy with your returns, and move on. You do not have a crystal ball, so you could not have possibly known that the stock would fly so much higher after you sold.

Control

The only way I have found to control the demons in the profit-taking process is to have your own personal set of sell rules that work for you, and you stick to those rules come hell or high water. To illustrate this, I will share what my sell rules are for most of my trades.

• Once I am happy with the gains on a trade, I will hold the stock as long as it continues to move higher, and sell immediately on any sign of a pullback. I am usually "happy" with gains when they exceed 2%. Once they get past that, I like to watch it like a hawk, and sell at the first sign of trouble. Sometimes that happens right away, other times the stock continues to rise far beyond my wildest imagination. But I find this is that happy medium between fear and hope that works well for me.
  
  
• If the stock quickly surges for a windfall, I will sell unconditionally, immediately. For quick trading, I define a windfall as a gain of 4% or more. Remember that I am referring to quick gains, in less than 30 minutes. If the stock runs up to 4% very slowly, I apply the rule above—I watch it until it starts pulling back. But if the stock spike up like a bat out of hell, I just sell and don't try to second-guess anything else. Don't look a gift horse in the mouth!
  
  
• If the trade struggles or goes sideways for a while, I dump it as "dead money" if there are little or no gains, otherwise I wait for a tiny spike upward and then sell. I usually allow about an hour of sideways trading before making this decision.
  
  
• If a profitable trade is hitting a resistance level, I will usually sell. A resistance level is a price in which the stock just can't seem to get through. Often (but not always), it is an even number, like $10 or $20, and I believe that is because even-number boundaries are psychological to other traders and they sell at those round numbers.

Your sell rules should probably be along the same line as those above, but you can modify them according to your own preferences, risk tolerance, etc. But there is one general rule that I think applies to everyone, and it is hard to go wrong with this one:

Generally, take gains when you are happy with them.

This may sound too simplistic, but it is the #1 rule that I apply. At the end of the day, your best approach is to exiting a trade is when you are satisfied with the gains that your trade has made. You don't have to be ecstatic, or be thrilled with a windfall, you just have to be happy with the profit your trade has returned. (And, if the stock takes off higher, you remind yourself that you just made a nice profit, and it could have been much worse).

Half Positions

Another thing you can experiment with is the half position strategy. This is when you sell half of your shares when your trade has shown good profit, and let the other half ride a little longer. If nothing else, this handles that infamous "stock taking off" phenomenon after you sell.

To do so, however, you need to have a large enough position to make selling half worth your while, because you have to contend with paying extra commissions. But if I have a fairly large trade (say, 1000 shares or more), I will often sell half of shares, or maybe 2/3, then see what the remaining shares do. If they struggle or begin to slide back, I dump them; otherwise, I let them ride for even higher gains.

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