How to Control Losses on the Stock Market - dummies

How to Control Losses on the Stock Market

When you start trading on the stock market, you need to know how to control your losses. Your level of risk seeking or risk aversion is personal. Therefore, nobody can design loss-control rules for you. You must do it for yourself:

  • Would you faithfully follow every buy/sell signal generated by a given indicator when the backtest of the indicator predicts that you will have some individual trades that entail a loss of 50 percent of your trading capital?

  • How much of your trading capital are you prepared to lose? Your answer is critical to whether you succeed in technical trading. If you say you can accept no losses at all, forget technical trading. You will take losses in technical trading. If you say that you’re willing to lose 50 percent in a single trade — whoa, Nellie! That’s too much. After three or four losing trades in a row, you wouldn’t have enough capital left to do any trades.

Experienced traders ask themselves, “How much will I lose today?” when they wake up every morning. They expect loss on some level. In contrast, beginners find losses almost impossible to contemplate. Yet if you don’t control losses, the question is not whether you go broke, but when you go broke (as a famous trader named W.D. Gann wrote on the very first page of one of his books).

Exiting a losing trade is the single hardest thing to do in trading:

  • Exiting means that your indicator let you down. Accept that your indicators have shortcomings and that your job is to overcome those shortcomings by using money-management rules.

  • You may have a bruised ego. To sell a losing position means that you failed, and the standard response to a loss is denial. “It will come back!” you cry. In the long run, maybe it will come back. But by then, you may be broke and unable to take advantage of it.

Every top trader admits to taking bigger losses than they planned. Many go out of business for a period of time, only to come back later with essentially the same indicators — and better ways to manage the trade. In fact, some investors say that the best time to place money with a professional trader is right after he has taken a fat loss — because then he’s a better trader. Note that such investors aren’t predicting he will be a better indicator analyst, but a better trader.