Last weekend I began a three part series of articles dealing with cutting losses and letting profits run. In the first part, I discussed the advisability of the process and suggested the first two steps that need to be accomplished. The first step was to recognize the importance of the concepts in achieving trading and investing success and the second was the necessity of formulating a specific and personalized plan as set out in "Trade Your Way to Wealth" and "Smart Investors Money Machine." This week, my focus will be on relatively precise ways traders and investors might consider in establishing a plan whereby they can cut losses.
One of the first things to recognize in investing is that we can't know how a trade turned out until it is closed. In other words, we find out whether we won or lost and we find out how much only when we exit. Therefore, to my mind, the exit strategy is critically important and it is the precise formulation of that exit strategy that sets us up both to cut losses and to let profits run.
It is my belief that in order to effectively cut losses we must have an exit strategy in place before we ever enter a trade and the entry should be based upon the initial exit. I want to enter a play in such a position that if I am wrong on the direction and the stock turns against me fairly quickly I am out of the play with only a small loss. As you can see, that philosophy first encompasses the concept that I could be wrong and that I could suffer a loss. The simple fact is that anyone who trades will, at least at some time, suffer a loss. Since that is the case, the first criteria for me in establishing an exit strategy is that I want the losses when they do come to be as small as possible. I need to emphasize, however, that does not mean there is no rationale for setting the point at which the loss is to be cut. That is one important purpose of the plan. I want to use some discipline that takes me out when the stock price moves against me in some pre-determined fashion.
There are probably as many ways to plan that exit as there are traders and I am going to explore a few of the possibilities here while also looking at some considerations in determining what method to use. In general, when buying a stock, the highest risk of loss is often near the time of entry. That seems true because there are ways to at least attempt to protect profit as the price moves in the direction you want. Initially, then, I suggest that each trader or investor decide upon their personal real risk tolerance. In that vein it is important to understand that there might be a significant difference between what one thinks their risk tolerance may be when getting ready to enter a trade and what it actually is going to be when real money is being lost. This step involves a little serious soul searching, and only once determined can we use a specific loss cutting method.
Once you have decided what you are really willing to lose on any given trade, it is time to decide on what loss cutting exit strategy you will use. One specific way to cut losses is to employ a strict percentage approach. In your plan, you might decide that if the stock price drops 5% from your purchase price you sell and cut your loss. This basic methodology is suggested by William J. O'Neil, publisher of Investors Business Daily, in his popular book, "How to Make Money in Stocks." In the book, Mr. O'Neil suggests cutting the loss when the price is 7% or 8% below the price you paid. That may or may not sound like a lot to any individual trader or investor and that is where the personal decision must be made. However, the important point is that it does provide a disciplined loss cut. If the stock price drops a percentage that you determine in your plan then you get out with no if's, and's, or but's. The loss is cut. There can be no argument that "it'll come back" or "I'll just let it go another 10 cents." Create the parameter and follow the discipline.
As I mentioned earlier, the percentage loss cut is definitely not the only way to discipline loss cutting. I personally use some basic technical formation for many of my exits. Take, for example, a situation where a stock we'll call XYZ has just formed a double bottom bouncing off a level of support. I may choose to enter on that bounce and use a retreat back below the support as my initial (and I emphasize initial) exit. Let's say the stock formed the double bottom by dipping to $15 and then moving up on two separate occasions. The double bottom support would be at $15. I would like to catch it shortly after the bounce so suppose I entered at $15.20. I would make my exit a break below support and might set a stop loss to close the position at $14.90. That means that if the stock price dropped to $14.90 or below, my position would automatically be sold as an "at the market" order. One caution I should include is that a stop loss order does not guarantee that you will get the price at which you set the stop loss. It only assures you will be sold out of the position. Suppose that with my stop at $14.90, XYZ gapped down from $15.10 to $14.30. The gap would have gone through my stop and my stock would be sold at the market which might then be expected to be around $14.30.
Another way to specifically cut losses might be to use a break through a moving average. Suppose you see a stock bouncing up off the 50 day moving average and decide you would like to buy it. The exit could then be a break below that same 50 day moving average. As an aside, that could also be used as a way to let profits run, but that is information for Part III next weekend. Any moving average could be used as the exit trigger, not just the 50 day. I often personally use a variety of others, but the important thing is that I know which one I am going to use before I ever enter a position. A last thought for now is that I might also use a trend line exit where I exit the play on a break through the trend line.
Each of these methods is relatively simple, but serves the purpose of setting a disciplined exit; one that is not dependent upon whimsy or emotion. If whatever line is chosen is broken, the idea is to just get out. The stock price movement tells you when to exit. Always remember if it turns back your way you can always re-enter a position.
by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved
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