Perhaps the most basic concepts necessary to achieve profitable trading are to cut losses and let profits run. The idea is obvious and simple on its face, but it seems that many traders have no idea how to accomplish either objective. In fact, I would hazard a guess that a majority of retail traders do just the opposite. They cut profits and let losses run. That is an almost certain road to losses and frustration.
Recently, a commentator on the blog took me to task and suggested that I use the concept of cutting losses and letting profits run as a tease and suggested that I write a little about exactly how to do those things. I can only guess that he has not been following my articles for very long and has not read my books because I have tried to deal with the "how to" aspect many times. My coaching sessions focus specifically on those actions as they apply to the individual with whom I am working. Accepting all that, I, nevertheless agree with the comments insofar as I believe it could be extremely helpful to at least some readers to discuss specific ways to cut losses and specific ways to let profits run. This article, therefore, is the beginning of a three part series in which I'll try to suggest ways in which the individual can set up his or her trading so that they do cut losses and let profits run in ways that could work for them.
The blogger suggested it would be a cop out to say that the "how" of cutting losses and letting profits run is an individual decision. In that regard, I believe he is mistaken. Each of us must determine the methodology that fits our personal risk tolerance, our goals, our available time, our knowledge base, and the strategies we utilize and with which we are familiar. For example, someone who only trades stocks may have a much different loss cutting strategy than someone who trades call ratio backspreads and someone whose primary strategy is selling options may have a different approach than someone whose primary strategy is buying options.
Recognizing that how we cut losses and let profits run is, indeed, a personal decision and should be part of an individual plan, we can still explore some of the basic concepts that we might consider applying no matter who we are or what our strategy might be.
As many of you may know, in addition to private coaching, I have taught a number of trading seminars over the years. In addition, I often get calls from other traders and often speak with people who have questions regarding trades or investments. With that background I would suggest that it is fairly common that retail traders generally buy stock with the hope that it goes up in price. They tend to enter positions for a variety of reasons, and, among those reasons, may rely on something they have read or heard on TV; they may get a tip from a friend who already owns a stock or is about to buy it; they may act upon a broker's suggestion; or they may have some personal knowledge gained through research or some first hand experience. In many of those cases they are buying a story; a story usually with some basis in fundamentals. When they buy, they give little or no consideration to their entry price, particularly as it might relate to an initial exit in the event the stock turns against them right away. The entry is made with little consideration of how much is actually at risk and with little or no consideration of how much they are personally willing to risk in the trade. Often these are the people who have been taught that the only way to invest is to buy and hold and they will defend "buy and hold" with great fervor.
In its purest form, the strategy of buy and hold generally has no plan as to when or how to cut losses. Positions are simply to be held no matter how much the stock drops. Any exit strategy is ordinarily based on need or whim. The question I always ask buy and hold investors is: "Hold until when?" I usually get a blank look. Hold until death is certainly a strategy and one that may be wonderful for the heirs, but maybe not be so good for the investor. Using this strategy, profits may well run and that is generally something we want to achieve, but so too do losses. Anyone who held the likes of Lehman Bros., or Enron, or Bear Stearns knows exactly what I am writing about. So too, albeit to a lesser extent do longer term holders of issues of even great companies like GE or CAT or MSFT. Of course they may "come back" and hopefully they will. But why hold them during the downdrafts; why let big profits turn into big losses?
If you accept my arguments so far, it only seems logical that you would agree that the first part of cutting losses and letting profits run is to have a plan. Using a plan, you can create a disciplined structure in the beginning that will dictate at what point to get in and at what point to get out. In other words you can set yourself up before entering the position with a trigger mechanism that extricates you relatively quickly from a losing trade and keeps you in a trade that is winning until it turns against you. I discuss precisely how you can create such a plan for yourself in "Trade Your Way to Wealth" and in "Smart Investors Money Machine." In my view, without such a plan one has no disciplined basis upon which to cut losses and no way to make sure profits are permitted to accumulate.
The first key is to recognize that cutting losses and letting profits run can be instrumental in realizing success in trading and investing. Once accepted, the next step is to create a plan for yourself whereby you set out where and how the losses are to be cut. That involves some system to determine the level of loss you are willing to accept and that will be the subject of Part II of this series. Next week, we will look at very specific ways for you to determine the "where" of the loss cut. In addition, we'll address certain orders that traders and investors might consider to implement the loss cut. Once the initial level of acceptable loss is determined, we need to structure the trade in such a way that we try to attempt to avoid cutting profits. In Part III, I'll discuss specific ways a trader can attempt to continue to capture profit while letting the play continue so that profits that are running can continue to do so.
As these articles are published, I expect to be traveling in Ireland so please don't expect me to respond as regularly on the blog as I ordinarily do. Feel free to have an open civil discussion. Let me suggest that there are many, many ways to accomplish the objectives we are discussing here and there is probably no one perfect way. Be tolerant and open to the suggestions of others. We always learn more when we are willing to listen than when we try to force our own beliefs down someone else's throat.
by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved
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