Watching a trade move swiftly into profit then reverse back can be a painful experience.
Psychologically, these are the moments that can cause you to go on ‘tilt’ and abandon your trading plan altogether.
When I first started trading I remember jumping on board fast trends in the FTSE only to see them wiped out in a matter of seconds. If only I had a way to lock in profits my career as a futures trader might have lasted a little longer.
Today, I trade stocks and I always have my exit plan laid out in advance. I also use a technique called top slicing so that I don’t experience the pain of seeing a big winner turn into a loser.
What Is Top Slicing?
Although it’s a very simple concept I first heard about top slicing from Investors Chronicle analyst Simon Thompson.
All you do is sell a significant part of your investment at a higher level but leave a little bit there to capture any remaining upside.
For example, let’s say you bought 100 shares of Apple at $150 and have a price target in mind of $180.
Top slicing means you would exit 70 or 80 percent of your trade at $180 then leave the remaining 20 or 30 percent of your capital in the market ready to capture any remaining upside.
The beauty of this approach is that you bank some profits but still have the chance to run the trade a little longer. Apple is going to have to drop a long way now for you to lose money.
The other advantage of this technique is that you can free up some cash and margin for another trade.
A Recent Example In CVRS
I recently had the chance to execute a top slicing trade in a stock called Corindus Vascular Robotics (CVRS).
(Apparently CVRS manufactures systems that allows robotic surgery to be conducted at long distances. It’s all news to me but my system provided the signal so I followed it. I even wrote a short blog post on it and posted it to Seeking Alpha).
You can clearly see from the chart above that CVRS is a volatile small cap. I entered a trade on Thursday morning around $1.60 per share.
These stocks have been doing well lately and I was pleased to see a 25% gain after only two days in the trade as the stock hit $2.
Anything Over 20% Is Good For Top Slicing
I’ve conducted extensive historical analysis and backtesting into these types of stocks and I know that a move over 20% is usually a good candidate for top slicing.
Remember, these stocks are volatile. They often whipsaw back and many will eventually end up worthless. In fact, I found that around 40% of micro caps end up losing half of their value.
A 25% move over two days is a sharp profit so I sold two thirds of my position on the next open and I left the remainder to run on.
I’m still in the trade with the remainder and I will keep it on until I get my standard exit signal.
Other Ways To Exit A Trade
I find that top slicing works best on volatile markets like small cap stocks or thin futures markets.
When the market isn’t so volatile other approaches can work better. I’ve talked about these exit types before and I’ve also backtested them to see how effective they are:
Trailing stops work by locking in your profit as you go along which means you capture a nice chunk of profit but you do experience a pullback right at the end of the trade.
A lot of traders use break even stops because they provide psychological benefits. All you do is bring your stop up once your trade is in profit and then you can let it run… a free trade.
This sounds good in theory but the problem with break-even stops is that you can end up scratching lots of good trades but still taking losses on bad trades.
Most of my research has shown that break even stops are not a good choice and you are better off with a trailing stop, profit target or top slicing.
The usual wisdom says profit targets should be avoided because they cap your winnings which goes against the idea of letting your winners run.
However, I’ve found that profit targets do work well especially in the stock market.
I’ve found that simple percentage targets and volatility targets (such as ATR) work best and they work equally for trend following and mean reversion strategies.
Twenty percent profit target works well for small caps, whereas one percent or three percent works well for ETFs.
The Best Of Both Worlds
But as I alluded to above, the top slicing technique offers possibly the best of both worlds because you get to capture a good chunk of profit while simultaneously letting some of your profits run on.
I’m a big fan of anything that can improve win rate and consistency and I’ve found that top slicing does that.
Thank You For Reading
Joe Marwood is an independent trader and the founder of Decoding Markets. He worked as a professional futures trader and has a passion for investing and building mechanical trading strategies. If you are interested in more quantitative trading strategies, investing ideas and tutorials make sure to check out our program Marwood Research.
This post expresses the opinions of the writer and is for information, entertainment purposes only. Joe Marwood is not a registered financial advisor or certified analyst. The reader agrees to assume all risk resulting from the application of any of the information provided. Past performance is not a reliable indicator of future returns and financial trading is full of risk. Please read the Full disclaimer.