An Update On The “Rule Of Thirds”

I’ve been fielding a lot of questions from new Maximum Profit subscribers about the way we use what I call “profit target” prices.

If you’re not a subscriber, that’s okay. You may remember I wrote about the “rule of thirds” in April of last year… this is essentially what we’re talking about.

My philosophy is that if one or more people have the tenacity to ask a question, then it’s a good chance that even more people have wondered something similar to themselves.

So I want to quickly recap how this works today. We’ll also cover the purpose — and my reasoning — behind this.

Trying To Nail The “Top”

First, understand that I’m constantly trying to figure out ways in which my subscribers and I can book profits quicker or nail the exact top — or as close to it as possible. Unfortunately, there’s just no magic potion, indicator, or holy grail that tells us when the top is in and it’s time to book our profits.

Anyone who says otherwise, turn and run the other way.

But allow me to be frank… Although I’ve had more my fair share of winners over the years, one of the biggest frustrations I’ve experienced is sitting on a big winner only to see a hefty chunk of my profits evaporate before I sell. This is a problem all traders face.

Watching gains evaporate into seemingly thin air makes us second-guess our approach. If we’re not careful, it can make us second guess everything. We begin to play the “woulda, coulda, shoulda” game in our heads.

If you’ve been trading for long enough, you can probably think of a time when you were in a similar situation.

To help curb some of these frustrations, I found (through backtesting) that locking in profits can help us squeeze a little more profit out of most of our trades while helping keep some sanity while trading.

Of course, there are some downsides to this approach, which I’ll discuss in a bit… But first, let’s talk about how it works.

The Rule Of Thirds

The rule of thirds consists of pulling 1/3 of our trade off of the table as our shares rise. Let me give you an example of how it works with a recent trade.

In September 2019, the Maximum Profit system flagged Paylocity (Nasdaq: PCTY) as a buy. We added the stock to our portfolio on September 20 at $98.83 per share. We hit our trailing stop loss on March 9. We closed out of the trade the next day at about $116 per share.

We made just over 17% on the trade, which means you would have made over $1,700 on a $10,000 investment. It isn’t anything to write home about, but it still crushed the broader market’s 3.7% loss during that period.

However, by using pulling profits at the designated target prices, we would have squeezed another 13 percentage points out of the trade.

Here’s how it works…

For every trade we enter, I will set profit target prices. Once we hit that target, we will take 1/3 of our trade off the table. We will have our first third, our second third, and then what I call our “Runner”.

Our first third will be set at 25% above our entry price. Our second third will be set at 50% above our entry price. Finally, with our Runner, we will simply ride out until one of our Maximum Profit sell signals are triggered.

Now, let’s go back to that Paylocity trade and see how we would have done using the profit target prices (there will be a bit of math here so bear with me).

For my hypothetical, I will use a $10,000 investment. This means we divide $10,000 by our entry price of $98.83 per share, which gives us 101.2. Since we can’t buy fractional shares, we round down to 101. We split our 101 shares into thirds. 101 divided by 3 gives us 33.7, so we round up to 34 for our first two profit targets, and that leaves us with 33 shares for our Runner.

In short, we will sell 34 shares if we hit our first profit target price, 34 shares if we hit our second price target, and 33 shares on our Runner.

With Paylocity, our first profit target price was $123.54 per share (25% more than $98.83, which was reached on January 2nd, 2020.) That triggers our first sell, which pulls 34 shares at $123.54, or $4,200, off the table.

Our next profit target price was $148.25. Shares of Paylocity hit that figure on February 4, 2020. So, we would have sold 34 more shares (our second third) at that price, which gives us about $5,040 ($148.24 x 34 shares) that we pulled off the table.

Now, we are left with our Runner. We let this go until one of our sell signals are triggered — either Paylocity’s relative strength falls below 70, or our trailing stop loss is hit.

We stopped out of Paylocity when shares closed below our 20% trailing stop loss on March 9. So in this case, we sell our remaining 33 shares the next trading day for around $116 per share — $116.03 multiplied by 33 gives us about $3,829.

Now if you add up all of the proceeds ($4,200; $5,040; $3,829) we get $13,069, which means on our initial $9,981.83 investment we would have made over 30%. Compare that to our original return of just over 17%.

That’s an extra $1,350 in your pocket by simply following this profit-taking rule.

Closing Thoughts

I personally use this rule on speculative trades in my personal portfolio, and I’ve had great success with it.

Now, I realize this requires a little more babysitting than you may be used to. But it also offers some advantages that can really work in our favor.

For one, by using profit targets, we are adding back trading capital for other opportunities. It also gives us some peace of mind that we’ve already locked in profits. We’ll realize we’re beginning to play with “house” money and will worry less about the trade.

Some things to keep in mind…

The biggest impact you’ll see with this method is on our massive winners. I’m talking about our triple-digit winners. While we will still make great money on these trades, by taking profits off early we wouldn’t enjoy the full return that we’ve seen on some of our big winners.

In my opinion, that’s okay. Because when the market isn’t climbing on a near-daily basis and things get choppy, that is where this profit-taking approach will shine. We will be happy that we pulled profits and added capital back to our trading stash.

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