Back in the 90’s, when internet stocks were going berserk, I had a friend who was just out of law school and decided to dabble in the markets while looking for a job.
He had a small account and put some of his money into America Online stock. As he was interviewing with law firms, he noticed that his stock was taking off, moving up almost every day.
His account began to grow, so he bought more and more AOL. His account value hit $250,000, then $500,000, and then $750,000. It seemed as if he could do no wrong with AOL, so he stopped taking interviews and decided he was just going to live off the profits in his trading account.
His account continued to climb higher, and one day I asked him when he was going to take his profits, to which he replied, “When it hits one million dollars, I am going to close it out, and travel the world.”
For a young man in his mid-twenties, a million dollars was a ton of money and his account value finally hit a high of $970,000 – just before the long running internet bubble began to burst.
After the first substantial decline, he told me that if his account got back to $750,000 he would sell it all.
You probably know the rest of the story.
As his account value plummeted, he repeated his mantra, first with $600,000, then $500,000, then $400,000, and so on.
He took his position all the way back down to below his original account value and thus began knocking on doors of law firms to try to get the job he never thought he would have to.
The takeaway from this cringe-worthy tale is that when setting stops and targets for trading, they have to be chart based, and not money based.
The market has no idea that you exist, and thus, its movements have no relation to how much you are up or down on your position.
The movements of the market are related to areas where there is support and where there is resistance – whose strength is based upon the number of buyers and sellers in those areas.
If you set a target on a position based upon a desired account value, which requires the stock to move above a resistance level, it may never get to that price. Likewise, if your stop is determined by account value, which requires you to sell above a support level, you might get taken out just before price turns and rallies.
The way to convert from $ based stops or targets to chart based ones is to start by reverse engineering your position sizing.
This takes away the emotional aspect of managing a position and allows you to trade better, and based upon what is happening in the market, instead of what is happening in your head.
For more info on reverse position sizing, check out this post.