You just bought a stock, and it is already going against you, what do you do? Do you let it keep going in hopes that it comes back to where you bought it, or even higher, so you make a profit? Do you let your emotions take over, and think to yourself,”it will comeback, I was right when and why I bought it”.
This is what can go through your mind each and every trade, the key is, do you let your logic or emotion control your decision making? In trading, that can be quite possibly what makes or breaks your trading career. Let a loss get too big, and you could be done, before you really even get started.
Hopefully you have learned from this type of loss before, as I feel feeling the emotions that come from an unnecessarily large loss are invaluable, but if you have not, then heed the warning, as when and if it happens, and its your first time, it can knock you on your ass.
Let’s get to the real meat and potatoes of the main reason you should cut your losses quickly (and often) along with letting your winners ride.
Loses suck, nothing can ruin your day like losses, or how Gordon Gekko would put it, “Nothing ruins my day like losses, nothing” So if you like losing money, then stop reading right now. When you take a loss it does more then affect your account balance, but it can also affect your mental state, decision making and just about everything that is important when you trade.
One of my biggest and most important rules in trading is this, Never. Ever! Take a loss more then 10% of your entire account. This is huge, as once you do this, you are going to start compounding what you need to earn on you next trade to break even, let me visualize this for you.
10% Loss = 11% Gain to Break Even
20% Loss = 25% Gain to Break Even
30% Loss = 43% Gain to Break Even
40% Loss = 66% Gain to Break Even
50% Loss = 100% Gain to Break Even
75% Loss = 400% Gain to Break Even
If that doesn’t help you to understand why you should cut your losses quickly, then you need to be on some sort of medication. If you let a loss get to extended, you are going to have to make it up big time on the other trades, which don’t come around very often.
Let’s go ahead and take a look at an example trade, and why cutting those losses, even before you take a 10% loss is important to your trading and mental state. Now if you trade like me, and take short quick gain’s of around 0.5% – 5% then this will help you out.
You have a $2,000 account with this great broker and you have $12,000 to trade with based on margin, you see a stock that is near a $10 breakout point and you decide to risk your $2,000 along with $8,000 in margin. You buy the 1,000 shares of the stock right when it hits $10 for a position size of $10,000.
Now, I like to take profits along the way on the breakout, BUT this is a fake breakout, the stock hits $10.02 and instantly turns south on you headed right back below $10 a share and is now at $9.94 for a paper loss of $60 (3% Loss).
Do you take the loss of 3% ($2,000 is your money) right now or let your trade pan out, thinking “its a breakout and maybe it will go back higher, maybe risking a max 5% ($100) loss on the trade which put the price of the stock at $9.90.
You must make your own decisions on this, but my advice which I detail in this blog, is that you should have your trade planned out before you enter it, what you are willing to risk on the trade vs what you are trying to make. IE 2:1 or 3:1 risking a $100 loss for $200 gain or $100 loss for a $300 gain. (I generally shoot for a Risk Reward ratio of 3:1 on each trade I make)
So you decided to hold and now you are even past the 5% loss area, as you let your emotions get the best of you and sell your entire position at a 7% loss ($140) at $9.86. So lets do the math of what happened to your account buy cutting your loss at only 7% vs 10% 5% & 3% from $2,000.
3% Account Loss = $1,940
5% Account Loss = $1,900
7% Account Loss = $1,860
10% Account Loss = $1,800
You can see how cutting your loss quick in this situation can save your account.
Now, trading with margin obviously increases your risk level when you trade, so you must be very careful in the first place, as your trading with funds that are not yours. If you have enough money to day trade ($25,000) then this does not apply to you.
Never take on to much leverage that It can cloud your judgement and change the way you can trade, this can pretty much spell disaster to your account, and you can blow up easily. Just remember to always pay attention to your open positions, never take more then a 10% loss on one trade, and always, always cut your losses quickly!