The goal of every trader is to make money. In order to make money, it is important to avoid losing money. One of the best ways to avoid taking big losses is to take small losses before they become big losses. While this may sound simple enough, it can be rather difficult to actually do.
The problem stems from the inability of most traders to admit that they are wrong. After investing a number of hours analyzing a particular stock, it can be very difficult to admit defeat. It is much easier to hold on hoping for the stock to bounce back.
“The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses.” – Ed Seykota
Managing Your Risk
When it comes to trading, very few things are within our control. Any number of things can drastically alter the path you expected a stock to follow when you established your position. Sometime a stock behaves differently than expected with no visible reason at all. Sometime a position will turn south despite all of your analysis being correct. This can be very difficult for a new trader to handle.
It is important for traders to focus on what they can actually control. You can’t will a stock to move higher. No amount of worrying can influence an earnings announcement. One of the few things that a trader CAN control is the exit point.
Successful traders determine the maximum loss they are willing to take on a position before they enter the position. While the exact amount of risk a trader can tolerate will vary, this process of determining that risk ahead of time is something that all great traders are adamant about.
[Related Tip: Use a Stop-Loss Order To Manage Risk]
In order to profitably trade unpredictable markets, you need to focus on aspects that you can control. The amount of risk you take on is one of the few things that you can control.
After you establish an exit point that you will take if a trade goes against you, the next step is having the discipline to stick to the plan if the trade goes bad. This is where new traders are first tested. Setting a “hypothetical” exit point is easy to do because most traders don’t really believe that a position is going to go against them. Most traders, especially new traders, believe that they are going to be successful immediately.
It can be a startling wake up call when a position goes against you. You will likely find a dozen reasons to rationalize a position’s behavior. Successful traders don’t try to argue with the market to prove themselves right. They simply follow the plan they established and take the small loss before if grows into a big loss.
Big Losses Start As Small Losses
Losing 10% of your portfolio would be a big hit, but you could recover. Losing 20% would require a lot more determination to come back. If you were to lose 50% of your portfolio, you would have to earn 100% return on what you had left just to break even. That is the kind of loss that traders don’t come back from.
The important thing to remember is that every 50% loss started out as a 10% loss. The trader simply didn’t take the 10% loss and it grew a lot bigger. Always keep risk and discipline at the forefront of your trading strategy and remember to take the small losses so that you can avoid the big losses.