In stock trading we often here that we should cut our losses when the trade that we’re in doesn’t go in our favor and turns against us. This makes plenty of sense especially if you understand that this also aids in keeping your overall P@L higher by giving you a respectable average loss number lower than your average win number.
Now, this seems easy on paper, so why do so many beginner traders have difficulty applying this method? There are 3 main reasons we find that is often the source of why some traders find it so difficult to cut losses quickly.
#1). Not using stop loss. This is simply the number 1 reason we find as to why a lot of traders find difficulty in cutting losses quickly. When you trade with a stop loss, you are often subject to unplanned actions during the trade. For example, Someone who never uses a stop loss often says things like “I will get out when the price is at $10 per share. When it gets to that $10 per share they often adjust that mental stop loss by thinking ” Maybe ill get out at $9.80″. This happens far to often and often because the trader is focused on hoping the stock will return to whatever price he/she wishes. Instead they should be focusing on picking a stop, setting a stop, and RESPECTING THE STOP.
This leads to
#2) Not being disciplined/ Sticking to your rules. There are those who do use stop losses but adjust there stop to give the stock another chance because they are hoping the stock rises back in there favor. When you do this over time, all that the trader is allowing is for bigger losses. Once a trade stops working in your favor you should move on. This is why some of the better, more experienced traders will often cut there losses even before there stop loss gets hit. They do not need to let the price go lower to meet there stop if there are already signals telling them that the trade is no longer working. I have a personal example of this.
I use to skip the option to use stop losses at all and went with the “I will get out with the mental stop” mentality. After I went through every single trade I made and recorded the profits and loss from each trade. It concluded that instead of being down close to $2,000 at the time, I would have only been down $200+happening if I had cut my losses at 4% each trade that I lost money. Now i personally don’t believe in a strict percentage number to cut losses because I would rather have a range (I will talk about that range in reason #3), but it just puts into perspective of how much you can lose if you don’t manage the trade properly.
#3) Not knowing what is an appropriate cut off price/percentage. There is a problem with both ends of this dilemma. One is setting stops too tight, the other is setting them too far. I’ve seen people who say “I cut all my losses at 3%”. This can be good and bad. Its good because your losses will be relatively small overall. The bad part is you will probably be getting stopped out left and right. Especially dealing with volatile stocks, in order to make money consistently on the them you must allow them to move first. If your stop is too tight at first , then you will often get taken out of the trade only to see the stock do exactly what you expected. The opposite to this is when people put there stops way too low. So low that there might as well be no stop loss to begin with. The method I was is one a learned from a professional trader and is used my many types of traders. I simply put my stop loss at relatively close, maybe 5%-7% of capital risk. The whole point is to give the stock room to move, but as the stock moves in my favor, I adjust my stop closer to my entry. The further the stock goes in my favor, the more I adjust it. Once the stop loss is at my entry(or a little higher to cover commissions) I am stress free knowing i wont lose any money on this trade. Even as it continues to go higher, keep adjusting the stop, but not too close. Still give it room. When the stock doesn’t go in my favor, depending on what it is doing , I will adjust the stop to cut the loss sooner instead of letting it hit the stop all together .