In response to my article on stops last weekend, a coaching student of mine wrote on the blog about using a 50 day moving average as an exit. Although seemingly doing pretty well (reported just closing a +35% trade), she commented that in two instances when a position had penetrated the moving average she waited a couple of days "hoping" the stock price would rise and when it didn't, finally took the larger loss. That makes my student the member of a large club whose members, on occasion at least, have failed to do what they originally had planned to do in cutting a loss.
Who among us can say that they have never been a part of that club? To those who can, I applaud you because I firmly believe that following one's exit plan can be a critically important element in trading successfully. I blame our failure to adhere to our original exit plan even once a price has passed our pre-determined exit point on that 'little voice' inside us that often encourages us to hang on because "it'll come back." That is the voice of emotion and it can be very difficult to ignore. We just don't want to take that loss even though we know intellectually that it may lead to an even bigger loss down the road. We "think" it will come back but seem to fail to consider that it could also continue to move against us.
If we set our exit strategy before we ever enter the play, we are doing it at a time when our emotions are not so strong. We are doing it out of the heat of battle when we can see a reason for our discipline. Following that discipline rather than the voice of emotion during the gyrations of a trade can help us to make better trades. Changing from the thoughtful discipline constructed as we planned the trade means we are no longer willing to accept our thoughtful decision because it will require us to take a loss. The point was, however, back as we were planning our trade we understood there was a risk and we decided exactly how we would attempt to limit that risk to a specific level. In the heat of swirling emotions during a trade when things go as we thought they would not we are susceptible to the suggestions of our 'little voice' whose advice I have often heard but have found to be mistaken quite regularly. Suddenly, we decide to let a loss run because "it [might] come back." Might not, too.
When we listen to the 'little internal voice' and stay in a trade beyond the point where we had previously chosen to exit we are making a decision to let our losses run. All too often the loss goes from dimes to quarters to dollars or worse. How about getting out when and where we planned to cut our losses and then getting in when it turns our way again. I've heard it said that some of the best traders will enter or re-enter a position 4 or 5 times before it goes their way.
Setting the exit strategy, the discipline, is extremely important in my view, but it is useless if we then fail to follow it. It seems equally important that once set the discipline be followed. I definitely do not mean this as a criticism. That little internal voice is probably in us all to one degree or another and it is one of the things that makes us human. My advice is simply to be aware that it is there and that while ever present it may not always suggest the best course of action, especially in our trading.
by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved
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Bill: Great article. I used to be a charter member of that club. Has the exit strategy in place and then dropped it before it executed ... and then lost a TON. Today I have religion and I never bail on an exit strategy. I get ticked when my stop is right where the stock turns around and heads back up but not mad enough to violate the rule on the next trade.
Holding on to a predetermined stop is not my problem. Wheather or not to use a mental stop or place a mechanical stop is.Would prefer using a mechanical stop but doing this reminds me of playing blackjack in that one is showing the dealer where he or she is going to fold ahaed of time !!Would like commeds on this paranoia.
This is the best and most important column that you have ever written, I know from experience and have paid the price many times over for having ignored the concept.
Hi Bill, I'm hosting a blog carnival for traders and investors. I've enjoyed reading your articles for a few years now, and would like to include them in the carnival. It's easy to submit articles. Check out the site and see if you might be interested.
Setting stops is too often practically a guarantee of the loss. Trailing stops as well. This is based on dozens of outcomes of trailing stops on Ameritrade.
Setting a simple limited sell upward gives much, much better result.
The reason is in inevitable momentary fluctuations of the price. Some spike on opening that lasted for 5 seconds and then instantly recovered, but your stop has been activated. Perhaps if it was possible to set stop only reacting on "true" decline in price (for example, lasting for at least X seconds), but it's not possible, and spikes are way too frequent to ignore them. With that in mind, only the stop protecting from really catastrophic loss makes sense. Way, way below the current price.
Equally, some momentary spike upwards rips you the profit. The stock trades at 50, you set sell at 55, and 3 days later you see it's sold, even though that 55 was hit just once on opening for 3 seconds, and then went back.
Thanks, Anonymous and congratulations.
Aye, there's the issue, Tony. Market makers know generally where the stops are going to be anyway so I think the key is to put stops close but just out of reach and that can come only with experience. Mental stops are fine IF the trader actually acts when they are hit. If he doesn't, mental stops are useless. Thanks for an important comment.
What happens when it falls before hitting your price dzinto? You automatically cut your profits and as far as I can tell let your losses run. This is based on thousands, not dozens, of trades.
I like the statement "I've heard it said that some of the best traders will enter or re-enter a position 4 or 5 times before it goes their way". I think part of my hesitation comes from just not wanting to do the accounting for tax season on the wash sale. Can you point me to a good article on how to handle wash sales? Maybe if I understood it a little better it wouldnt bother me.
You raise an important issue, Don. Since it sounds like you may not be using a tax professional you may just want to Google "wash sale tax rules." The IRS also sets out the rule with example I believe in their publication 550. It really isn't all that hard to do (like many things) once you know how.
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