The market basis (S&P 500) touched support at 1343 which represents a 0.618 Fibonacci retracement of the June 2012 low to the September 2012 high. The market has since mapped out a price structure called an “inverted head and shoulders” which defines it as stage one accumulation. Stage one accumulation phases are those times in the market which pre-date a large expansion to the upside. Inverted head and shoulders patterns can be viewed as high momentum patterns. At a sector, industry and stock level we can observe many patterns displaying high momentum structures poised to break to the upside in the near future. The strongest sectors are Financial, Health Care, Consumer Discretionary and Industrials.

To view our previous market forecasts go and review previous blog postings. If you are interested in a review of the stock markets we deliver free presentations on the first Thursday of each month. Follow the registration links on our Stock Market Report page if interested.

What Is Writing a Naked Put?

When you write a naked put option you guarantee to purchase the underlying stock at the strike price on or before expiration. If the taker or holder of the put option exercises the option, you may be assigned the stock. That would mean that you must take delivery of the stock, and you must pay for that stock at the strike price. The put option will be exercised if the underlying stock price is below the strike price. Therefore, if exercised, you must pay more than the market price to buy that stock. The premium you receive when you write a put option compensates you for the risk that you will be assigned and have to pay too much for that stock. You keep the premium irrespective of whether you are assigned. I argue below that the risk is not worth the premium income.

Why Might You Write a Naked Put?

You might write a naked put to earn premium income, hoping that the option would expire worthless. The option would expire worthless if the underlying stock price remained above the strike price. So you should only write a naked put if you forecast the stock price to remain steady or to rise, and not to fall below the strike price. You should not write a naked put if you forecast the stock price to fall. Therefore it is a neutral to bullish strategy.

It would be wise to choose a strike price such that the option will not come into the money because you hope to keep the premium without being assigned. The strike price should represent a floor or support level below which you believe the stock price will not fall.

If you forecast the stock price to rise you might want to own the stock. You might argue therefore that if the price falls below the strike price, you could purchase the stock at a discount. Writing the naked put locks in a low future purchase price. This logic is flawed. It involves “flaky thinking”.

Flawed Reasoning

The problem is that market sentiment can change during the period after writing the naked put and before expiry. The stock can change from desirable to undesirable from bullish to bearish while you are exposed to the naked put. If the stock price falls below the strike price the stock price is falling. But if you have written a naked put the price shouldn’t have fallen below that level. The falling price renders your bullish forecast wrong. Therefore you should no longer wish to own that stock.

You might have been happy to purchase the stock at the strike price when writing the naked put, while the stock was going up, and when the strike price appeared to be a bargain. But if subsequent events cause the stock price to fall, then the price is going down. The reasons for wanting to own the stock probably no longer exist when you are assigned, which is probably why the stock price is falling.

Pay-Off Diagram

The pay-off diagram below shows the potential profit and loss outcomes of naked put options written over NuVasive (NUVA) stock. The solid line represents the profit and loss outcome at expiration; the lower broken line represents the profit and loss situation today. We might choose such a stock because we forecast the price to rise, and a high implied volatility means we might be paid a good premium to write put options. With the underlying stock at $28.58 (at the vertical cursor), fifty put option contracts with a $25 strike price expiring in thirty-three days time were written for a premium of $1.00 (per share), or a total income of $5000 before brokerage. The strike price was chosen because we forecast that the stock is unlikely to fall below $25. With the stock at $28.58 we have leeway of $3.58 before the price reaches $25. That strike price permits an adverse price excursion down to $25 before the option comes into the money, before our forecast is proven wrong, and before the risk of assignment can materialize.

nuva profit loss

Serious Concern

The first thing you should notice is that if your price forecast is wrong, and the stock price falls, you could lose lots of money. The line slopes down to the left all the way to zero, far off below the diagram. The word naked is used because there is no protection, or cover, against the downside. The worst case loss is the strike price less the premium received, which is $25.00 minus $1.00 = $24.00 per share, or, for fifty contracts, $120,000. That should cause very serious concern.

The term “cash covered” is at best a euphemism which means that if your forecast is wrong you will lose a lot of cash. The only cover you have is your own cash. Normally when we use the word “cover” we mean that risk is covered by a third party. But in a cash “covered” naked put, the term is misleading because you are covering yourself. That’s why your broker will only allow you write the naked put if you have the cash to cover the purchase of the stock if assigned. Being cash covered means you are not at all covered. The analogy would be to have no house insurance because you are covered instead with lots of your own cash.

The second thing you should notice is that profit is capped. The maximum profit can never exceed the $5000 premium income. Although this might seem attractive, it is much more important to consider the reward in proportion to the risk. Ask yourself: would you really ever risk taking a $120,000 worst case loss to make a potential but not guaranteed profit of $5000? Remember: there is no guarantee that the stock price will remain above the $25 strike price. Your forecast could be wrong. Other people are paying you $5000 to entice you to take on that risk. They are paying good money because they seek to offload that risk, in some cases onto the unsuspecting.

There’s More to the Picture Than Profit and Loss

Some argue that the pay-off diagram is identical to the pay-off diagram of writing covered calls. Writing covered calls is an acceptable option trading strategy. They conclude therefore that writing naked puts is an acceptable option trading strategy.

This argument is flawed because there is more to trading than mere profit and loss at expiry. The decisions to buy, write or hold involve considerations not shown on the pay-off diagram.

Despite having identical pay-off diagrams, the underlying reasons for writing covered calls are significantly different from the reasons for writing naked puts. And they are more sensible. Writing covered calls is a bullish strategy, so owning the stock is desirable. You would write covered calls on stock which you already own, and which you intend to keep beyond expiration of the options. Writing covered calls is ideal if you hold stock investments for the longer term. If your bullish stock forecast proves to be wrong and the stock price falls, you should close your covered call position and sell your stock, because you are wrong, and because the stock price is falling. But if the stock price falls and you have written naked puts, you are obliged to buy stock which is falling in the opposite direction to your forecast. Why would you buy a falling stock?

Moreover if you open a covered call position you are entitled to ongoing dividends. The pay-off diagram does not show the cumulative effect of dividends earned beyond expiration.

Unacceptable Risk to Reward Ratio

Our Options21 options mentoring clients know that you should only ever trade if you strictly define and limit your worst case potential loss at all times: before opening the position; and throughout the entire trade. If you don’t control risk at all times, emotion will eventually pollute or override your trading decisions. If you trade stock options you should always strictly limit the worst case loss, and ensure that potential loss does not exceed 2.5% of your trading account. You will eventually go broke if you do not control your risk. The sensible way to trade stock options is with small risk and large reward: not large risk for small reward. The written naked put strategy offers the worst of both worlds. It has unlimited downside risk. And it has limited profit to the upside. The risk to reward ratio of writing naked puts is the wrong way around.

Why Would You Buy a Falling Stock?

The naked put option strategy is irrational. Why would you want to buy a stock whose price is falling? You should only buy stock if you forecast the price to rise, and if the price rises to confirm your forecast. In writing naked puts you should intend not to be assigned. The intent is to earn premium income, and keep all of it. Therefore you should choose a strike price below which you forecast the stock will not fall. If the stock price falls below the strike price the stock is not rising: it is falling. Question why the counterparty would buy your written put. Often they would buy the put in order to protect or hedge their stock investment against a price fall. They will no longer wish to hold the stock if the price falls below the strike price because that means the stock has turned bearish.

Fatal Flaw in The Written Naked Put Option Strategy

The fatal flaw in the written naked put option strategy is the time delay between opening the position and the time when the stock price falls below the strike price. The stock might look attractive to buy when you write the naked put, but things can change subsequently. If sentiment turns negative after you write a put option, and if the stock price falls, you probably might no longer wish to own the stock. The problem is that the written naked put option obliges you to buy the stock, and at a premium to the market. In a sense the option strategy could be viewed as a trick used by others to offload unwanted stock onto you at a premium.

The strike price might look like an attractive purchase price at the time of writing the naked put. But the reality is that if sentiment turns negative and the stock price falls, the strike price is no longer attractive. The fact that it might have been attractive in the past no longer matters. It is irrelevant that the strike price is low compared with a past price. The fact is the strike price is high compared with the present price, so you would be paying too much. The strike price can no longer be attractive if the market price is lower. It is not rational to buy a stock which is not good value now because it was good value in the past.

Paying Too Much For The Stock

If you did decide to buy the stock, why pay more than market price? If the stock price falls below the strike price, and you still wanted to buy the stock, the written naked put obliges you to pay too much. The strike price is higher than the market price. If you really wanted the stock it would be better simply to buy the stock on the market, at a price lower than the strike price, and without the complication and risk of writing a naked put.

Worst Case Disaster

Options can be exercised while the underlying stock no longer trades. Even the “best” companies can be bankrupted and have their stock suspended from trading. Companies fall into administration or receivership every year, rendering their stock worthless. If you wrote naked put options over a stock which subsequently became suspended, you will be exercised and obliged to purchase worthless stock at the strike price. If the stock from the earlier example went bankrupt you would be obliged to pay $125,000 for that worthless stock. Even if the stock had some form of residual value, you would not be able to sell that stock if trading has been suspended.

The Odds Are Against You

The idea of earning premium income by writing naked options is a game of statistics which should only be played by large players. Individuals should not insure houses because they do not have the resources to spread risk across many transactions. Only large insurance companies should insure houses. If you write naked puts sooner or later you will be assigned and incur a very great loss: greater than you can bear. The premium income you receive is compensation for taking on the risk of making a huge loss. The market premiums are high because the market prices in that risk. The risk is real. The premium income is not free: it is fair compensation for taking risk. Would you insure somebody else’s house?

Sleeping At Night

How can anyone sleep at night exposed to a pay-off diagram as that shown above. Can any amount of money compensate for the worry? How many sleepless nights can a premium buy? There are some people who sleep very comfortably because they remain blissfully ignorant of the inevitable financial disaster.

Conclusion

I never write naked puts because it is irrational to risk so much for so little gain, and it makes no sense to pay a price above market to buy a stock whose price is falling. I only buy stock whose price is rising. The premium income earned from writing naked puts is illusory. It is statistically inevitable that sooner or later the writer will suffer a serious loss which will annul all gains, and much more. There is no free income, and the income from writing naked puts comes at a very heavy price. My trading style always allows me to sleep very well at all times.
Copyright © 2010 Nils Marchant, Options21.

Imagine my colleague Paul is fortunate enough to be in possession of 10 large boxes of beer, freely available from our local liquor store. Imagine also that I enjoy parties, and in an impulsive fit of haste I suddenly decide to throw a party tonight. Not having much time to organize things, I look across the office at my colleague Paul and ask politely if I could borrow his ten boxes of beer.

Paul agrees. I promise to return his beer within a month, and I take his beer home with me to prepare for my big party. Paul owns the beer, but for now at least it is in my possession. Because I don’t have enough time to get organized properly, hardly anyone turns up. The party is a failure. I no longer need Paul’s beer. But of those guests who do turn up, someone asks if they could buy my beer. They offer quite a good price. I agree to sell all the beer to the guest, I take the money, and I hand over possession of the beer. The guest takes delivery. There is a small issue in that it wasn’t really my beer. Later that week I buy an identical type and quantity of beer, and I return all the beer to Paul.

Paul doesn’t actually get back exactly to his beer. It is a substitute, but he is unable to detect any difference. It is precisely the same brand, in precisely the same packaging, and of precisely the same quantity. There is no difference between the borrowed beer and the returned beer except, maybe, if there are any little serial number markings on the sides of the bottles, the serial numbers won’t match. But who worries about serial numbers when it comes to beer? Paul assures me that he doesn’t mind that the beer is a substitute beer because it is the same brand, and Paul is happy and thankful that I’ve returned the same quantity.

Now we could ask a moral question: have I done anything wrong? I’ve sold something which I did not own, but I’ve made good. Is that moral or immoral? There is more to morality than merely deciding whether anyone suffered a loss or got hurt, but that’s the subject of a separate philosophical discussion.

My beer sale is one type of short selling. It is called covered short selling, because I had possession of the beer, I was able to deliver the beer to the buyer, and I fully intended to deliver the beer after taking the money, because I always deal “straight” and honestly.

What would happen if I placed large newspaper and television advertisements offering millions of cartons of beer for sale at a massively discounted price? People would buy less beer from their traditional liquor stores, they would defer their purchases in anticipation of lower prices, and the price of beer would fall.

But what would happen if I neither owned nor had possession of any beer, and did not intend to deliver any beer for any sale? I could for a short time influence the beer price by leading people to the false belief that huge quantities of beer are about to be unleashed onto the beer market at a great discount.

If there really was no beer available for sale the advertisements would have been false. People would soon discover that a huge warehouse full of cheap beer did not exist. The price of beer would rise again as people returned to their normal liquor stores. The beer price would have been temporarily distorted, through manipulation of perception and the creation of a false belief. Would I have done anything immoral?

Now imagine that Paul also own a significant number of shares in Google, the US internet stock.  What would happen if I borrowed 100 of those shares from Paul, and sold them into the market? Let’s say I sold the borrowed Google shares. The stock market operates on T+3, which means I have three days in which to deliver those shares after selling them. I have every intent to deliver those shares to the buyer, and indeed I do deliver them. I also have an obligation to give them back to Paul within one month.

Two weeks after I sold them, I could buy 100 Google shares back from the market, and subsequently give them back to Paul. They are probably not exactly same shares, but that doesn’t matter. Like the beer, Paul does not care that the share certificates have different serial numbers. All that matters is that Paul has been returned the same type and quantity of shares. He is grateful to have his portfolio restored with the return of his shares. I might even offer Paul a small amount of money to compensate him for renting or leasing his shares to me. Would I have done anything immoral in borrowing and selling Paul’s shares?

This type of transaction is also termed covered short selling because the shares I offered for sale were “covered” by the shares in my possession, even though I was not the legal owner of them. I had the owner’s consent to sell them. I was able to deliver the shares to the buyer, I intended to deliver, and indeed I did deliver and make good the sale.

It is legal to short sell shares on the Australian and US markets, as long as the seller has possession of the shares and intends to deliver them to the buyer. Often a broker will hold title to many clients’ shares. Brokers are able to lend those shares to other clients if they agree to return them. In that way those other clients can short sell shares. Short selling is very risky. It is possible for short sellers to lose a lot of money if the shares have to be bought back at a subsequently high price in order make good the loan and to return the shares to the broker and the rightful owner. Indeed, short selling exposes the seller to potentially unlimited risk. We strongly recommend never to short sell shares without some form of hedging or protection.

Some people short sell because they might determine that a company is badly managed and foresee a fall in value. They can exploit that forecast for profit simply by short selling the stock and buying back the stock later at a lower price. Short sellers often identify badly managed companies early, and perform a useful function by exposing bad practice and bringing to the early attention of the market useful negative information which might otherwise be concealed for a longer time. Obviously covered short sellers would only target poor quality companies. They wouldn’t short sell without a sound reason to believe that the price would be likely to fall. They might have more information, or they might have a sharper perception of the true state of the target company. The threat of short sellers helps keep businesses disciplined. Without short sellers, imprudent, stupid and bad practice within a company can be hidden and perpetuated more easily, sometimes at the expense of the shareholders.

Legal covered short selling can hasten and temporarily amplify a fall in the share price. But legal covered short selling can not sustain a fall in the share price because ultimately the shares must be returned their owner. Buying the shares back from the market tends to push the price up.

Some superannuation funds and other fund managers hold large amounts of stock which represents the investment funds entrusted to them by their clients. Some of those funds lend, lease or rent those shares to short sellers, knowing it may well drive the price down. Is that appropriate or moral for fund managers to do?

Google is a large company, and my sale earlier of 100 shares could not affect the share price. But let’s now consider a very small company, maybe like a small gold mining or exploration stock which does not have many shares on issue, for example 50 million shares or so. What would happen if I placed an order to sell 20 million shares, “at market”? What if I neither owned nor had possession of any shares I offered for sale? What would happen to the share price? It would fall. That type of short selling is called naked short selling. It’s naked because the sale is not covered by my possession of the actual stock. Would that be immoral? Does anyone suffer?

Naked short selling is illegal, both in Australia and in the US, where we do most of our trading. It falsely inflates the number of shares available, and unfairly destroys the wealth of the real shareholders. The share price of any particular stock is due in part to the scarcity of those shares. There should always be only a fixed number of shares on issue and in circulation at any one time. Naked short selling brings shares into the market which don’t exist. And because shares are interchangeable and indistinguishable from one another, like bottles of beer, the newly sold shares dilute the value of all the shares. Naked short selling creates the perception that there are more shares in existence than there really should be. That is why naked short selling is illegal. It falsely and unfairly pushes down the share price. The share price no longer reflects real supply and demand, or the scarcity, because the false short sales interfere with the number of shares available to the market.

If shares are sold, and those shares not delivered within the prescribed T+3 time limit, red lights and alarms are signalled to the exchange regulators. Even though it is illegal, sometimes, some people do try to distort the market price by offering stock for sale which they neither possess nor intend to deliver. They might want to drive down a company’s share price to acquire the assets at below cost.

In mid-2008 the US Securities and Exchange Commission made the curious announcement that it would temporarily no longer tolerate illegal naked short selling on 19 selected financial stocks. The implications are bizarre.

Options are very different from shares. Shares are issued by a company to those investors who provide equity. Although those shares are identical and interchangeable so that they can be freely traded, the number on issue is always strictly limited because each share represents a fixed share of the company. It is the fixed limit on the number of shares which creates the scarcity which supports the value and price of those shares. The shares can exist in perpetuity, and are only created or destroyed in an orderly manner to reflect capital adjustments. Only the company can issue shares. No one else can create shares in that company. If anybody other than the issuing company attempted to create a share certificate that would be fraud.

Beer is different. Beer can be consumed. In fact lots of beer can be consumed. It also can be manufactured easily in vast quantities. Scarcity is not really a factor in determining the price of beer. In the case of Paul’s beer, I wasn’t concerned that the buyer would consume it because I knew more would be manufactured. The price of beer closely reflects the manufacturing, distribution and taxation costs, at least where it is freely available. Beer is not really a good long term investment, because unlike shares, there is not normally a strictly limited supply, and it is perishable.

Options can be created out of thin air, as it were, more easily than beer can be created. And options always have a strictly limited life span. They perish with time. Options cease to exist when they are exercised or when they expire. In effect options are either consumed or wasted, just like beer.

It is more appropriate to liken options to insurance policies than to shares. Options are a contract between a writer and a taker. Any participant in an options trading market can be a writer, and write options for those takers willing to pay the premium. The value in options thus does not lie in their scarcity. When an option is written the writer is paid a premium to take on risk which the taker seeks to cover, or transfer to the writer. The writer takes on obligations to deliver or to buy stock at a fixed price on or before a fixed future date. Options are standardized and indistinguishable from one another (that is for a given stock, strike price and expiry date) and thus can be freely traded, just like shares. But the inherent value of an option is not related to its scarcity, because there is no limit on the number of options contracts that can be opened.

When a writer writes an option the terminology is sometimes used that the writer is “going short” the options. The writer is not actually selling anything which is scarce. Nor is the writer interfering with the free market price of those options. Therefore going short options is not at all the same as selling short shares. But the terminology used is similar.

There are two ways in which options can be written.  Options can be written “naked”; or options can be written “covered”.

Whenever writing options the writer should always first ensure he or she is in a position to fulfill the delivery obligations under all circumstances, regardless of what might happen, in case the taker or holder of the option exercises the option.

Writing covered options means the risk taken on by the writer is already covered in some form, or hedged, or insured. For example writing a covered call means the writer already owns the underlying stock which the writer might be obliged to sell if the call option is exercised. Moreover, the holder of an option may decide to sell that already existing option into the market, which would simply be a plain sale.

Writing naked options means the options are written without any protection, thus exposing the writer to potentially unlimited risk. Writing naked options would be similar to an insurer writing an insurance policy without setting any limit on the maximum amount agreed to be paid out. We strongly recommend never to write naked options because of the unlimited risk it would expose the writer to. However to write naked options would neither be immoral nor interfere with the fair operation of the market.

So in summary, we’ve now defined two types of short selling, and for both stocks and for options.

Covered short selling of shares means the seller possesses the shares and intends to make good the delivery of those shares for sale. Covered short selling of shares is legal.

Naked short selling of shares means the seller does not possess the shares to be sold, and therefore can not deliver them without acquiring them from some other source. Naked short selling of shares is illegal.

Covered short selling of options, or covered writing of options, means the writer has hedged the exposure to risk. Naked short selling of options means the writer is writing options without any protection against the risk taken on, so the writer is exposing himself or herself to seriously large downside risk. Both styles of options writing is legal.

Thank-you.

Copyright © 2008 Nils Marchant.

This is an edited transcript of the talk first delivered to the Options21 Market Briefing on the 31st of August, 2008.

The market (basis S&P 500) has approached long term resistance at 1481. Its recent high was 1474.51. Price has mapped out a structure called an “M” Top which defines it technically as a stage 3 distribution. Stage 3 distributions are events that occur over a period of time, culminating in a close below a 20 period SMA (Simple Moving Average), and a trade and close below the short term trend of the market, as defined by an upward trend line. In light of the fact that we are in an environment of QE3 (Quantitative Easing 3) and that US presidential elections are soon to conclude we believe a stage 4 counter trend will be relatively shallow, setting the market up for a strong upward push into the end of the year.

If the index is upward moving in a low momentum fashion, it is ideal for selecting stocks with high percentile ranked premium that could be traded using Bull Put Spreads. A Bull Put Spread is an option strategy designed to capture a net credit from the buyer of the options. Bull Put Spreads are best initiated in low momentum upward market moves with stocks that have put options with high percentile rankings. That is, options that when written were expensive with the expectation that as price rises the puts devalue in price. As prices rises and implied volatility falls the puts devalue in price. And finally as time moves forward the theta of the options (time decay) devalues the put options price.

It is the interaction of time, rising low momentum price, and falling implied volatility that has delivered numerous highly profitable credit spread trades to our Options21 Traders’ Group over the past two months. Traders’ Group is held every Thursday evening at 8pm AEST Australia. If you have any questions, I am always happy to receive your email via paul@options21.com.au.

The US dollar index appears to be in the process of doing the reverse with the formation of a distribution phase (Stage 3). A declining US dollar index will put upward pressure on all asset classes.

We conduct market briefings on the first Wednesday of every month. They are broadcast live and free. Please visit our our market briefing page for upcoming times and dates. If the times and dates on offer are not suitable for your time zone please register anyway and you will be emailed a link to the recording once complete.

The US dollar index appears to in the process of doing the reverse with the formation of a long term accumulation phase. An upward moving US dollar index will put downward pressure on all asset classes.

Throughout November we started to view the market as an accumulation phase. Over the next two weeks I will explore a short term view of the S&P 500 and examine in the second week a much longer term view.

Short term view:  Since the end of November the market has been tracing out a series of higher highs and higher lows at 1, 2 and 3 (see chart below). In addition it has broken above significant swings at A and B (see chart).  Price action has also demonstrated strength by trading above its flattening 200 period moving average. Of importance it should be noted that the market has been accelerating above its 20 period SMA with only one visitation to the average since mid December. After a high momentum move since mid December we currently view this market as over-extended to the up side and we expect a counter-trend to develop. The evolution of a counter-trend will be defined by an “M” top, a close below the 20 period SMA, and a close below the rising trend line. These three events have not occurred yet, but if they do they would be an indicator for an impending fall. Next week we will look at the long term view.

Note: please click here to see a PDF version of this article with images.

If you do not always implement a reliable exit strategy, your trading success will be far from what it could be, or should be. Your profitability will be unreliable. You will tilt the odds of success against yourself. That can lead to greater losses, unhappiness with your trading performance, and even a lack of self-confidence.

Why You Need an Exit Strategy

You only make profits by exiting your trade: never before. By applying your exit strategy reliably on every trade, more of your trades will be profitable. Your profits will tend to be larger. Over time you will become more successful. And for losing trades, your losses will tend to be smaller. Emotion will no longer pollute your decisions. And you will never allow an unrealised profit to turn into a loss.

You need to have full confidence in your exit strategy. Because I trust my exit strategy, it is psychologically easy to implement automatically on every single trade. You should never experience doubt, confusion, or hesitation.

The Three Phases of a Trade

Every trade has three phases: entry; management; and exit. Each phase will have its own exit strategy. Your trading will be more successful if you let profits run, and cut losses short. That means you must always define where your forecast is wrong, before you open any position. As soon as your forecast is proven wrong: close your position immediately. Salvage what remains. You no longer have any reason to remain in that trade.

Stop losses define when you must exit your trade. I use three stop loss methods, one for each phase of my trades:

• entry stop loss, set prior to opening the position;
• trailing stop losses, set as the trade moves in my favour; and
• profit stop losses, to capture profits after reaching my waypoint.

I always set my entry stop loss before I open my position. For bullish trades, I set it at one per cent below a recent significant swing low on the daily stock price chart. If the stock makes a daily closing price below that entry stop loss, I exit immediately the next morning. My forecast was wrong: the stock is going down, not up.

If the stock moves up as forecast, and if I am not stopped out at my entry stop, I ratchet my trailing stop losses upwards one per cent beneath subsequent swing lows. I only ever ratchet them upwards. The ratchet effect reduces potential losses, and then locks in increasing profits. My trailing stops are also triggered by a daily closing price. Any daily closing price below a trailing stop loss triggers exit the next day.

*Please note: the images above are intended to illustrate the concepts, and they are not from the same trade.

Your Trade Waypoint

You must also estimate where you reasonably expect the stock price to go to. You must decide in advance how you will exit your trade to maximise your profits when you reach your waypoint. When your trade reaches your waypoint you need to implement your exit strategy with strict discipline. It is not a good idea to simply exit the trade when you reach your waypoint. It is better to remain in the trade as long as it continues to run in your favour. But you should get out of your trade at the first sign that the market is putting your unrealised profit at excessive risk.

When I reach my waypoints I use much tighter exit criteria, which trigger exit more readily. Having had a run up, the stock is more likely to turn down than continue up. I only stay in my trade while the stock continues to move up. Each day I shift my profit stop loss upwards to the intra-day low. As soon as the stock trades below yesterday’s low, I exit immediately, for, by definition, the stock has turned down. At that point there is a bigger chance that the stock will continue down than continue up.

Setting Your Profit Stop Losses

The market gives you many clues that your unrealised profits are at increasing risk. Profit stop losses capture unrealised profits at risk. You could use any one or more of the following criteria to exit to take profits. You could exit:

• as soon as the stock price turns against you;
• as soon as a trend line is broken;
• as soon as a price support level is broken; or,
• as soon as a simple moving average is broken.

Each of these conditions warns you that your trade has probably run its course, and that your unrealised profits are probably now at greater risk. If all of those criteria are met: you should definitely close your trade!

In addition to this standard procedure I might also overlay other stop loss strategies, based for example upon price chart patterns, indices, options premiums or time. For bearish trades I simply invert the process.

If you manage your exits in this way you will let profits run, and cut losses short. And that should prevent you from ever allowing an unrealised profit turning into a loss.

Copyright © Nils Marchant 2011.