Sunday, August 05, 2007

A Word About Losses

Last weekend, I wrote about the importance of having a plan and in the article, emphasized the importance of money management and exit strategy. I just can't say it strongly enough -- money management is absolutely critical to successful trading. No matter what anyone may say, some losses are inevitable. The recent market reversals show how markets can turn on a dime either up or down. Though it makes no one happy, everyone will suffer losing trades at one time or another and that can easily occur when the markets change direction quickly. We should keep in mind, however, that if we manage our money properly, losses only become a cost of doing business and do not ruin the business, itself. In fact, as discussed in my earlier article on money management, a trader can still make a profit overall even if more than 50% of his trades are losers so long as the money is properly managed.

If we accept the proposition that some trades will lose, we should also understand that it is important to limit those losses. A couple of market adages serve to underline that need: "Cut your losses and let your profits run." "The first loss is the best loss." These sayings have become cliche, but the fact that they are so well known does not mean that everyone knows how to achieve the goal. Assuming good money management, when does a trader exit a losing position? That may be the million dollar question. When anyone enters a trade, they are filled with a sense of optimism about the trade. That is a natural emotion, but it is an emotion. The fact that we enter a particular trade has absolutely no influence on what the stock price is going to do. We'll only continue to feel good as long as the trade goes in our direction. What we do if it goes against us in large part determines whether we will be successful traders or not.

Unfortunately, many people have no plan for their exit in the event the stock direction turns against them. All too many say to themselves: "It'll come back." Maybe it will and maybe it won't. That person has already been wrong on the direction so what is to say that the 'it'll come back' prediction is any better? Traders who find themselves in this situation seem to say to themselves: "If only it gets back to 'X', I'll sell." Ultimately, they seem to just give up and ignore the stock or finally just get fed up and sell. Often that sale is at or near the bottom and just before the stock turns back up. Their trading has been governed completely by emotion and as is often the case emotional trading dooms the trader to failure.

Traders emotion may be the most important factor in success or failure. The trader who is able to remove most of the emotion has a much greater chance for success than his emotion driven counterpart. As an aside, I should mention that I believe careful study of your own trading emotions can enhance your overall results. An excellent starting point for this study is Dr. Alexander Elder's "Come Into My Trading Room" (John Wiley & Sons, 2002).

One way to remove the emotion is to set an exit or exit plan before ever entering a trade. For example, suppose you buy stock as the price bounces up off the 50 day moving average. You could decide before entering that you will exit if the stock turns down below the same 50 day moving average. Since the moving average line will go up as the stock price moves up, your exit would also go up with the line. Profit would automatically be captured until the price finally breaks beneath the 50 day moving average. Of course, if the stock price dropped below the line shortly after entry, you would have a loss, but it would likely be small. The exit would be unemotional and disciplined; precisely what we want. There are many ways to set an exit but it is absolutely essential that the plan be in place before entry into the position.

I suggest that we understand that losses do occur in trading and not beat ourselves up when they happen. Instead, control our losses with disciplined money management and a disciplined exit plan. Undoubtedly this approach will have a positive affect on our trading.

Bill Kraft, Editor
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