"You can't go broke taking a profit." How many times has someone said that to you after you've just taken a profit that was smaller than your planned profit?

Oh, yes, you can go broke taking a small profit. Presumably when you tested and set up your trading plan, you anticipated taking profits at a certain level and losses at a certain level and had an idea of what your win/loss ratio would be. As is often true when you transition from back testing to trading live, you may find it more difficult to achieve your planned profit targets.

For example, it's possible that you find that execution may be more difficult than you anticipated. Perhaps market conditions change. If you're a good technician and you also keep up with planned economic releases, you may notice a troubling chart setup the day the day before a non-farm payrolls release. You may find yourself staring at the small profit your trade has accumulated. The next day's action could bring you more profit or wick away all your profit and deliver a loss. You decide to lock in that small profit.

Another time, a different trade may be close to expiring without having reached your profit target. You close it and take the small profit because you don't trade any closer to expiration. Before you know it, a hefty percentage of your trades were profitable, but at much less than your intended profit.

Let's look at some examples of what that does to your average profit. This exercise will be a little specious since I can make up any numbers I want, but putting numbers into the speculation sometimes makes a point better than just mouthing some warning.

I'm using a proprietary worksheet that I can't show you, but it starts with a trade using $10,000 margin, with an 83.33 percent win rate, a planned profit of $1000 and a planned max loss of $1500. That means that out of 60 trades, 50 reach full profit and 10 are closed at max loss. At the end of those 60 trades, the average profit is $566.67 or 5.67 percent of the margin in the trade.

No trade has results that clean, of course. Some trades work but don't quite work that well. Expiration or your planned time to take off the trade before expiration could approach without full profit being reached, for example. You may reach full profit and start closing the trade, only to have markets shift rapidly so that you incur slippage. The calculation doesn't include commissions and they could be minimal, in the case of verticals set up to either work or be taken off at max loss, or more substantial, in the case of a much-adjusted, hedged butterfly that you manage by the Greeks.

Let's look at a case when the trader tends to take smaller profits with more frequency. Let's imagine the case when twenty seven of this trader's trades still reached the planned $1000 profit, but the other 23 profitable trades showed smaller profits ranging $10-$900. The trader is still vigilant about holding losses to $1500, and her win/loss rate remains the same 83.33 percent. Adding up all the profits and losses returns an average $291.67 profit. This profit will also be reduced by commissions. Although 27 of the trades still reached full profit, the win rate remained the same, and only 10 trades hit max loss, this trader skates close to having a losing trade when all costs and slippages are included.

Am I saying that no matter what dangers arise in the markets, no matter what announcement is due or what negative chart signs are seen, the trader should hang in for full profit or full loss? Of course not.

However, if market conditions have changed or the live transactions turn out to be harder to manage than the back-tested trade and profits are frequently smaller than the planned profit, then the max loss must be adjusted downward. This is true even when the win rate remains the same and even when that rate is a high one. In this example, the trader did not "go broke," but all that would have been required would have been one of those crazy mornings when markets gap beyond an adjustment point and the loss is much multiple times bigger than planned, and this trader might have gone broke. When we transition to live trading from back testing or when market conditions change radically, we frequently find that our original trading plan requires some adjustments. One of those is likely to be an adjustment in the planned max allowable loss.