Today we’re going to leave world events alone and bring it down to the personal level. We’re talking about trading the market. The most important factor you must learn to control is inside of you. Your emotions and psychology.
This plays a vital role in your risk management. It directly impacts the dollars and cents you make — or lose — when you put your money on the line. The problem for a lot of people when they make a trade is that they don’t just put money down, they put their ego and self-worth down as well. A lot of bad decisions can flow from that dynamic.
Imagine, after you have done all the fundamental analysis and studied the charts, you buy a stock, but in just a short time you are holding a loss. It is human nature to hope the trade will turn around and go your way.
This is where people get into trouble. They start hoping and wishing for the stock to turn around. But the market doesn’t care about your profits or losses. It will do its thing regardless and you may find yourself struggling to close out a trade at the right time because to do so you have to admit you got it wrong.
Here’s the real deal: no one – and no system – is perfect. Remember that you can be wrong. And the way to protect yourself is to place a stop loss order at the time you make the trade. That way you can let the market do its thing and take your emotions out of it. Markets can move against you from time to time, but that doesn’t mean you can’t have overall success. If used properly, a stop loss can mean the difference between success and failure.
As simple as it sounds, it is one of the most important aspects to trading.
The lower a stock goes, the tighter you hold it
This is where reading a chart can be really helpful. A weekly chart, like the one below, takes out some of the market noise. Placing your stop loss at a prior weekly low (or level of support) ensures that your losses are kept to a minimum. If the stock breaks weekly support levels, then the chart is moving against you and the trend has changed.
In that scenario, you MUST get out of the trade.
Even if you are not using charts, you should determine a certain percentage that you are prepared to risk on each trade. Keep your stops tight. Yes, sometimes your stops get triggered, but you won’t stress nearly as much about the market because your loss is limited.
You’ve protected your capital to make more profitable trades in the future. Sure, sometimes a stock may rebound right after you’ve exited a trade. But most of the time you will find that the market triggering your stop loss is the best thing that could happen, because it got you out of the wrong stock before you rode it down to the bottom.
Do not hold onto a losing stock and hope. This is not a recipe for profit and success.
There’s one more thing — and it directly affects your stop loss: only trade in stocks with good volume. The price of stocks that are lightly traded can move in large gaps. Often you can struggle to get out at your designated stop loss and realise a far greater loss than you expected. Thinly traded stocks also tend to jump around a lot and are more likely to shake you out, that is, trigger your stop loss.
Don’t let a profit turn into a loss
When one of your stocks has seen some good gains, what is the sense of keeping your capital at risk? This is when you’ll want to raise your stop loss level. That way, even if the stock suffers a setback, you can get out with a profit.
If the trade continues to move your way, just follow it up with a rising stop loss. At some point you have to lock in those gains. A profit does not mean anything until it is in your pocket. So you need to study the market for likely times to sell or follow up with a rising stop loss.
Here’s another way to do that, with a simple moving average on the weekly chart…
Can you see that just by using a simple moving average (the red line), you can lock in profits. Once the stock falls below the moving average, you’re out of the trade. But not everyone does this. When they see a good profit many people expect more and more. They hold on and hope. Meanwhile the trend has changed and they let a profit turn into a loss.
Selling can be emotional. It’s important to check your expectations. Don’t expect to sell the very top or buy at the very bottom. Remind yourself that your job in markets is to make profits not losses.
If you are holding a big loss don’t beat yourself up about it. Do not use the markets as another vehicle to beat yourself up. Instead see every mistake as a stepping stone to progress. In fact, they’re not even mistakes — they are learning experiences. We all have them. The market will give you the lessons you need to learn how to be a better investor.
Analyse each trade and each time you will accumulate knowledge. Experience is the only school in which most of us learn — and having tight stop losses will allow you to keep your capital giving you the time learn how the market actually works.
If you find your stop losses repeatedly being triggered, stop trading, take a break and rest up. Let your mind rest and come back with a clear head, knowing you have capital in hand.
If you trade the trend and keep a tight stop loss, you should not lose money in the market. As for making big profits — there is no guarantee. First you have to master your own thought processes. To make a success of yourself in markets you must learn to master yourself. This is where the real work begins, if you have the time to put in, to observe, and master your own thought processes.
A stop loss is a critical risk management tool and can mean the difference between failure and success.
Waiting and hoping for stocks to turn around is not a recipe for success. Slumping stocks may take years to come back up, if they ever do. Far better to put your capital to productive use into stocks moving up already. For more on how to identify this trend, go here.
For The Daily Reckoning Australia