Today BHP hit the profit objective for the head and shoulders buy strategy I posted on 6 May.
When this happens, traders often ask - should I be taking profits here or trying to run this trend further? This post covers some of my thoughts on the subject.
The Set Up
By way of background, the chart below outlines the original strategy. For more details see the post BHP - Head and Shoulder Buy
Take Profit or Run the Position?
Let me begin by saying that my comments below refer to short term trading strategies as opposed to investing. Since the original strategy was based on technical analysis, I have also limited my comments to chart based trading.
That said, I think the answer to this question will depend on the type of strategy being used.
One of the foundations for successful trading strategies is that in the long run, they require a winning combination of success ratio (% of winning to losing trades) and pay off ratio (average $value of winners compared to losers) . There's often a trade-off between these ratios.
So strategies that aim for long run profit via a high pay off ratio in combination with a good enough success ratio are most likely to use techniques based on "running" trends as far as possible. The success of these strategies over time will often be based on a smaller number of really successful trades.
Strategies that depend on a good success ratio are more likely to involve getting risk off the table and taking profits at fairly modest objectives as a pathway to success.
Treating it as a new trade with a new stop loss.
A common approach by traders who use strategies designed to "run trends" is just to move the stop loss when targets are hit instead of actually closing the position at the target. Some may set a new profit objective with a new fixed stop loss level. Others may simply put a trailing stop loss in place once the profit objective is in place.
This leaves you in the market if the trend continues. Of course it also leaves risk on the table. There are bound to be plenty of times when you end up making a smaller profit instead of a bigger one using this approach.
One approach to this sort of technique is not to do it every time a target is reached. Instead look at the decision to run the trend as a new position. Then ask - does it make sense in terms of your original trade logic and most importantly in terms of its risk: reward potential?
Running the BHP trend - Does the risk: reward stack up?
The chart below looks at one approach to staying long in BHP instead of taking profit at 35.36.
I've cleared details of the original set up off the chart below and included some new informartion.
The first observation is that the current rally has so far taken a 5 swing structure. Although, we are currently in what looks like the 5th and possibly final swing it could easily go further. So staying with the trend does make sense in terms of the original trade logic.
Secondly, I've done some Fibonacci projections based on this 5 swing structure. This has thrown up a couple of Fib. clusters. As so often happens, the first to these is at the same level as the orginal Head and Shoulders measuring target.
This first cluster projects that the swing from 4 up to 5 will be:
- 38.2% of the whole move up to "3" and
- 127% of the length of the correction from "3" back to "4"
The 2nd Fib cluster is at around 35.80/35.90. This assumes the swing from 4 to 5 will be:
- The same size as the first swing (100%) and
- 161.8% of the 3 to 4 correction
I recorded a couple of videos on these Fibonacci techniques. You can access these the Fibonacci in Practice blog on 10 December last year
The strategy on the chart involves:
- Moving the stop loss under today's candle. If price makes a trend peak at the first cluster that's a sign of weakness and a reason to get out
- If price clears the 1st Fib cluster with a candle whose low is above it, move the stop up to $35.36. Once that's happened you are no worse off than if you had taken profit today
- Set a new profit objective at the 2nd Fib cluster
So our new trade would be:
- Effectively going long at 35.36 - this is the original profit level. You've decided to stay long here instead of taking profit
- Profit target 35.90
- Initial stop loss 35.08
Is it worth it? - This strategy would involve staying long in the hope of making and extra 54c but risking 28c (assuming no slippage on the stop loss and before financing costs). This represents a payoff ratio of 1.9:1. Every trader will have their own rules for this but my own view would be that 1.9 times the amount risked is pretty marginal for this potentially late stage in a 5 swing advance.