Methods to lock in profits using Fibonacci and the PSAR

Dec 3 • Between the lines • 3403 Views • Comments Off on Methods to lock in profits using Fibonacci and the PSAR

New traders will constantly see references to “locking in profits” and “moving stops to break even” and may be slightly confused by the meaning. In this article we’re going to discuss what we mean by locking in profits and later on this week we’ll also enter into discussion on what can be quite a contentious issues amongst experiences traders; moving the stop to break, even at the earliest opportunity.

Locking in our trading profits is a self-explanatory process. If our trade is developing the way we’d hoped and has gone into profit, we can apply, or adjust a stop in order to lock in some of the profit in the move.

For example, our trend/swing trade might be 200 pips up, we therefore might consider locking in the pips (or points) by moving the stop one hundred pips. This ensures that should the trade violently swing back in the opposite direction we’re still left with the sum of 100 pips for our efforts.

Unfortunately there is no right or wrong to this method and simply applying an arbitrary 100 pips to our stop often feels somewhat unscientific. Where we adjust our stop on our charts in order to lock in profits is often trial, error and experience, but we can offer a few suggestions as to how we can apply some ‘science’ to the craft of moving our stops in order to lock in gains.

We could use the Fibonacci retracement tool if we’ve benefitted from a substantial move. We can plot the high and low of the move we’re currently enjoying and then use the Fibonacci retracement tool in order to move our stop to the key retracement areas.

Fibonacci Retracements are ratios used to identify potential reversal levels. These ratios are found in the Fibonacci sequence. The most popular Fibonacci Retracements are 61.8% and 38.2%. 38.2% is often rounded to 38% and 61.8 is rounded to 62%. After an advance, technical traders apply Fibonacci ratios in order to define key retracement levels and forecast the extent of a correction or pullback.

Therefore if we’ve watched our trade move into profits of circa 200 pips we could use our stop to lock in profits should price retrace back to circa 38% of the move, or in this instance we’d be moving our stop roughly 38% of 200 to ‘lock in’ 200 minus 76 = 134 pips. Or traders could move their stop even wider by using the 62% retracement, 200 minus 124 pips = 76 pips.

We can clearly see how simple it is to use the Fibonacci tool in a major trend move and how easy it is to make what is a far more technical and scientific judgement on where to place our stop to lock in profits. We either protect versus a modest reversal, or a substantial reversal. Either value will ‘probably’ indicate that the profitable trade has come to an end, sentiment has changed and it’s perhaps time to consider stopping the trade and reversing trade direction. And we use the word “probably” deliberately; no one can predict with unerring accuracy just what the market in our chosen securities will do at any given time.

The Fibonacci retracement is, as we’ve demonstrated, a very simple tool to use. Many traders will alter their retracement values at the end of each trading day and adjust their stop accordingly. This is a time honoured method that many experienced traders will use as their locking in mechanism.

Let’s now look at an indicator based method to lock in profits as opposed to using our arbitrary judgement. Let’s use the PSAR. Before we do here’s a quick description of the PSAR and what it ‘does’;

Developed by Welles Wilder, the Parabolic SAR refers to a price-and-time-based trading system. Wilder called this the “Parabolic Time/Price System.” SAR stands for “stop and reverse,” which is the indicator used in the system. SAR trails price as the trend develops. The indicator is below price when prices are rising and above price when prices are falling. The indicator stops and reverses when the price trend reverses and breaks above or below the indicator.

The PSAR offers a terrific indicator based trailing stop mechanism and is favoured by many traders who like to keep their stops very close and their money management as a consequence very tight. The use of the PSAR for stops is quite contentious. Several traders suggest that trailing by one day’s candle is enough; other traders would suggest that the stop should trail by two days full candles. As with many techniques there is no exact preference, and many times you’ll move the stop too tight and it be triggered, therefore traders will have to take an overall wider, more holistic, view of their trades. However, the accepted wisdom is to trail by one day and to move the stop to the low of the OHLC candle, either Heikin Ashi or traditional.

Both these simple trailing stop methods offer up a more technical and scientifically based alternative to locking in profits versus guess work or gut feeling. The Fibonacci method offers up a method guarding against violent trend and sentiment reversals, whereas the PSAR method offers protection for those who work on tighter money management and are uncomfortable with too much risk.