The biggest losses that active investors suffer usually is a product of inertia. We know a stock is acting poorly but we find ways to justify holding on to it anyway. We don't want to admit that our initial positive belief was incorrect and that this stock is loser. So often good stocks come back from the depths so why shouldn't this one, we wonder.
The only thing worse than this sort of thinking is when we compound the error by putting more money into a losing stock as it decliners. The majority of traders that suffer catastrophic losses do the same thing. They take positions that are too large, keep adding to them as they sink and finally are forced to give up as the stock wallows in misery.
Everyone knows that the key to effective trading is discipline. We need to have a plan and stick to it. Discipline takes a variety of forms but the most important is the simple setting of stops. We give a stock only so much room and if doesn't perform then we cut it and move on.
It sounds very simple in principle but the actual execution is one of the hardest things to do in trading. We are driven to find ways to not honor those stops. Sometimes we do that by being vague about them at the initiation of a trade. "I'll see how this stock acts and then I'll set a stop." We never solidify our plans and then only give up on the trade when the loss becomes too painful.
In order to use a stop loss effectively it is necessary to embrace the fact that quite often the stop will be a suboptimal exit point. Most of the time it will feel like your stops are the bottom tick targeted by the market makers. The moment they are hit the stock will reverse and go straight back up. It is inevitable that will happen and it one of the easiest justifications there are for never setting a stop loss in the first place.
The value of stops will be found mostly in the small minority of trades where stocks fall and then accelerate quickly to the downside. Avoiding just a few of these substantial drawdowns will more than offset dozens of other stops that turned out not to be so timely.
There are many ways to set stops. Some traders use a certain percentage loss like 7% or 10%. Others will use technical levels like the 50-day or 200-day moving average. Stochastics, Fibonacci Levels, candlestick patters and so on can be used. There is no clear superior method. Some methods work better than others in different markets but it is not a static thing. The key is going through the process and have some form of discipline and then using it systematically. Any discipline is better than none. Use astrology or numerology as long as it is consistent. Don't entry a trade until you have a clear stop level.
Here are the keys to using stops.
- Stick with the plan. Don't look for reasons to modify the original stop levels
- The selling decision can be reversed. Just because you sell a stock doesn't mean you can never own it again. You just want to develop a better strategy the next time around.
- Rather than ignore your stops, sell the stock and then buy it back. If you have to pay a higher price that is just an insurance premium. Honor discipline first.
One of the great advantages of stops is that it frees you mentally and emotionally. If you have been a trader for a while you have likely experienced a situation where you have hesitated about selling a stock that is acting poorly. When you finally do dump it, you feel a sense of relief and wonder why you waited for so long. The inclination to hold a stock can be very hard to overcome. That are many people that become emotionally attached to their stocks and couldn't dump them anymore than they could dump a family member.
When it comes to producing exceptional market performance there is nothing more powerful than controlling losses. The market offers us an endless stream of opportunities and we squander them if we don't' cut the stocks that are lagging and stick with the winners. Cultivate discipline and watch your results improve.