Blog : The 1 Most Important Trading Tactic - Seriously

A paper cut hurts, but you aren't going to bleed to death.  You try to avoid another one next time.  The pain helped you learn, but there was no major injury.  In fact, you'd even pick up some paper again in the future, despite the risk!  You are so brave!  

 

 

You can't limit all your physical injuries in life to paper-cut status.  However, when it comes to investing, you absolutely can limit your losses.  The tactic is Stop-Loss selling, and anyone can easily do it.  But, there is a very right and very wrong way to go about it.

 

Tip:  I discuss stop-loss (cutting losses early) in this video

Simply put, you sell your shares NO MATTER WHAT if they fall a certain amount.  If you buy a penny stock at $2.35 because you think it is going to $10, you would unload that position if the stock falls to, say, $2.11.  (All examples, not trading advice!)

So, maybe the shares go to $8.55.  You would get that gain.

On the other hand, if the shares dropped to 10 cents, your loss would only be 11%.  Without the stop-loss, the investment would have dropped 86%.  The best (and most profitable) part is when you take the money you would have lost if you hadn't had a stop-loss in place, and invest it in that company at 10 cents!  You get so much more upside and can enjoy a MASSIVE gain (assuming the company is still good).

The benefits are major:

- your downside?  It is limited

- catastrophic losses...?  You easily side-step them

- pressure of investment decisions?  Eliminated

- time and effort?  You need way less

So, then why doesn't just about every professional trader use stop-loss limits on their trades?  

They do.

Stop-loss trading is so simple and massively effective, you may wonder why more people don't apply this tactic.  Well, the reasons are clear.  Most people:

- don't voluntarily give themselves a paper-cut (or sell for a loss)

- don't want to admit a trading mistake

- don't know about stop-loss selling

- blame their broker for not letting them set up stops

It is tough, because to execute a stop-loss, you may be selling shares of a company that you just bought (days ago, maybe hours ago), and which you know will go higher longer term.  Or perhaps you are not ready to admit a mistake.

Take it from me - the first few paper cuts sting a little, then you barely notice them.  As you suddenly are achieving consistent gains, and laughing at all the downside you avoided, those little cuts do not bother you any more.  You can actually get 75% of your decisions wrong, and still end up well on top.  Imagine getting 75% of them right!  That's when you never look back to the way you used to trade.

Personally, do I always use and abide by stop-loss prices?  No, but I wish that I had.  Take this quick 1 question test and just look at how this tactic would have helped you:

1 QUESTION TEST:  Consider your entire trading history - every trade you ever made.  Now, recalculate as if you had limited your downside to 15% on any one stock.  Would that have helped your portfolio?  Would you be in a better investment position now?

This is not even considering that the money you had 'saved' from disaster would have been re-invested in other opportunities.

The moral of this story:  Cut your losses early, and live to fight another day.

Tip:  Locking in Gains  

Remember, raising your stop-loss limits is a great way to lock in gains.  This is one of my favorite moments as an investor - when the shares keep moving higher, you can adjust your stop-loss price higher.  For example, picture having a $2.10 stop loss on a $2.65 stock.  When those shares drive higher towards $4.00, you might increase your stop price to $3.70.  If shares keep moving higher, let's say to $7.88, maybe you lift your stop price to $7.55.  Any time the company's fortunes reverse, or the shares drive lower, you will be one of the first to take your profits and jump.

Now, there are 2 major issues about setting stop-loss prices.

Especially for penny stocks, most brokers do not let you set automatic stop-loss orders.  This should NOT affect your trading tactics!  If we allowed our discount brokers to dictate the choices we made, we'd all be dressed like Buzz Killington, with a top hat, pipe, and monocle!

Instead, use 'mental' stop-loss limits.  Decide in your head the price you will sell the shares, and abide by that, no matter how difficult.  You could even set a price alert to automatically e-mail you when shares trade at a certain level, which can easily be done on Yahoo! Finance, through your broker, or just about any financial web site out there.

The hard part is following through.  Don't talk yourself out of selling, when you know the limit price was reached.  Most people justify ignoring their stop-loss, for dozens of reasons, all of which oddly seem to start with, "Well, it's just that..."  Some of these people are the same ones who tend to justify why it's ok to eat this, skip that workout, or buy those.  (I'm not judging anyone - I'm often the first to eat this, skip that workout, or buy those!)

With thinly-traded, volatile investments such as penny stocks, stop losses do not always work well.  For example, if a high quality company, like the ones we profile and analyze for our stock pick service, swings up or down by 35% from one day to the next, a tight stop loss of 10% would quickly get triggered.  

 

Often, even if you were committed to following the tactic, by the time you would go to sell, the shares have bounced back, and are above what they were in the first place!  In that event, should you still sell, simply because the stock dipped for a second, but now has recovered?

This is why the stop loss theory is more effective with higher-volume shares.  When a stock is less volatile, and more widely followed, stop-loss orders will be more effective.  With many of the smallest investments, stop-loss techniques will not help much.  Of course, a stop-loss will work well with those penny stocks with moderate to significant trading volume.

When applying the use of stop-loss limits, most investors are uncertain of the price to best set their stop.  If it is too close to the current trading price, you could get 'stopped out' just from the standard oscillation of the underlying stock.  You will almost certainly lose if your strategy is to set a stop-loss at one penny beneath the price you originally bought the shares.  Even on the way up, shares will bounce around a lot.

Investors often don't know when to sell (in terms of timing and/or price).  Well, the stop-loss takes the guess work out of the when.  As for the price, consider potentially using multiple stop-loss levels.  If a penny stock goes from $1 to $3, you may want to lock in some profits, but let the rest ride.  You could accomplish this by setting stop prices at (for example) $2.90 and $2.55.  

 

If the tighter stop price gets triggered, you lock in half your gains.  If the second stop eventually hits, you cash out fully.  The stock may be on the way down, and the first stop-loss price would start looking pretty smart.  The second (lower) one protects you from a major wash-out.

Most subscribers to Peter Leeds Stock Picks set stop-loss limits about 10% below their entry price.  Sometimes the shares sink, and they limit their loss to one tenth of their investment.  On the other hand, when the shares go where we expected, the gains are dramatically more than 10%.

In this fashion, you are taking a few small losses, while enjoying some significant gains.  This is not advice, just what decades of experience has taught me personally.  If you only learned 1 thing from me ever, I would want it to be this.  It will make the biggest difference of anything, in terms of your fortunes.