How to Set a Target Price to Handle Trading Losses
The most important concept of protecting your principal is accepting the fact that you made a trading mistake and moving on. Sell that loser. Don’t let a small loss turn into a large one. Before entering a trade, make sure you set a target price that you’re willing to initially pay for a stock, and set a target price for selling it if the trade results in a loss.
Setting a stop-loss price (or, as traders say, setting your stop) is more akin to an art than a science. You can employ several techniques for determining your stop-loss price. One that others often advocate, is choosing a predetermined percentage loss as your stop-loss price. Using technical analysis to identify when a trade has failed is a better approach. Here’s an example.
The daily price chart of the Gold Trust Shares (GLD) exchange-traded fund shows support and resistance lines, respectively, drawn on the chart at approximately $63.62 and $67.47 and indicates the ETF has just broken out of a long trading range on high volume. The breakout is identified on the chart.
This is a picture-perfect setup for entering a trade. Your entry point for this trade occurs above $67.50 when the ETF breaks through the resistance line. But how do you handle the trade if it doesn’t work out? Or, perhaps a better question to ask is, how do you know when the trade has failed?
One of several approaches suggests that if the breakout fails (the price declines below the resistance level), you need to exit your position immediately. For the GLD example, if the ETF were to fall below the resistance line ($67.47) after it breaks out above it, you should exit.
Another approach suggests that if the ETF falls below the midpoint of the trading range, in this case somewhere around $65.50, then the breakout buy signal has failed. In that case, you can use any price below $65.50 as the stop-loss price to exit from this position.
In the first scenario, the financial risk is small. As long as you get good fill prices (fills) on both your entry and exit orders, your risk should be no more than $1.00 to $2.00 per share, which reflects a loss of only 1.5 percent to 3 percent on the trade.
In the second approach, the risk is greater. The difference between the $67.47 breakout price and the $65.50 stop-loss price is $1.97, but the breakout gap means that your actual fill price will be $67.90 or more, resulting in a greater percentage risk on the trade. Poor fills on either entry or exit orders increase the amount at risk.
The trade-off between the two approaches is clear. The first one risks a smaller amount before triggering the exit trade, but it’s prone to whipsaws, which means you may be bumped out of a potentially winning trade. The second approach risks a greater amount but is less prone to whipsaws. Position traders who expect to hold a trade for several weeks or months are more likely to choose the second.
Either approach is rational, so you need to choose the one that you can live with. If you start second-guessing your stop-loss points, they’re no longer useful, so be sure to use an approach that you’ll honor.
Using the first approach may make more sense for new position traders, so tight stops can serve as educational tools. You’ll risk less on each trade, but you’ll be subject to a few whipsaws, and you’ll get into the habit of selling when you have small losses. And that’s a good habit to learn.