How to Make Money from Share Investing and Trading Through Using A Stop Loss Author: Sam McNeill, September 2009
A stop loss is a pre-determined price that we use as the trigger to sell out of a losing trade. If the share price falls instead of rising then we sell and we sell at a pre-determined price to ensure that we minimise losses. We need to have a stop loss price because not all trades succeed – some fail. Even the best trading techniques struggle to deliver a success rate of more than 70%. Therefore even using some of the best trading techniques we will still end up with two or three losing trades out of every ten. For these losing trades we must keep our losses really really small.
Another way of thinking about share trading is that any trade can only have one of five possible outcomes:
- A large profit.
- A small profit.
- Unchanged or breakeven.
- A small loss.
- A large loss.
That’s it. Five possible outcomes, no more, no less. Every single trade will result in one of these five outcomes. Now if we could eliminate one of these five outcomes, which one would we choose? That’s right - the large loss. If we eliminate the large loss we are only left with the other four possible outcomes. If our small losses, breakeven trades and small profits even out over a period of time we will only be left with the rather pleasing occasional large profit.
By now there should be no doubt in your mind about the wisdom of eliminating large losses. We use the Stop Loss to eliminate any large losses.
We use a Stop Loss Rule with three parts to it:
- Always have your Stop Loss in place for every single trade that you do.
- Your Stop Loss price is set at the level where your loss will be 2% of total trading capital.
- When your Stop Loss price is hit then you must sell. No ifs, no buts, no maybes. No waiting one more day/week/month/year until your trade turns into a “long term investment”.
For those new to share trading, and maybe some not so new, the most difficult part of this rule is part 3, selling when your stop loss price is hit. It’s the most difficult part of the rule because it brings into play your emotions. And of course our ego pops up and it just hates admitting that we were wrong about anything! Despite this huge emotional drag not to sell – sell we must. When your stop loss price is hit you sell. This simple and straight forward rule protects your hard earned cash.
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