Cut Your Losses Short
When you’ve figured out how to let your profits run, you need to start on the other end of the equation, and keep your losses short. This can be just as difficult to do as letting your profits run, even though it seems just as logical. Keeping your losses short preserves your capital.
If you’re not careful, the market will send you a few trades with the potential to create large losses, just like it sends you trades with the potential for large profits. But you really don’t want the losses. Before you enter a trade you should know exactly how much you are willing to lose on it. This is called your maximum loss.
The maximum loss is the greatest amount of capital that you are comfortable losing on any one trade. Your maximum loss should be set as a small percentage of your capital, so that a string of losses won’t stop you from trading. To use an example: If a trader had a trading float of $2000, and began trading with $200 a trade, it would be reasonable for them to experience three losses in a row. This would reduce their trading capital to $1400. Let’s say they then decide they have a better chance of winning because of the three losses and increased their next position to $400.
If a trader did bet $400 dollars on the next trade because they thought they were going to win, their capital could be reduced by half. The chances of making money now are practically nil because they would need to make 100% on the next trade just to break even. If you decide on your maximum loss, and then stick to it, you won’t ever find yourself in this position. Unlike the 95% of traders out there who lose money because they haven’t determined their maximum loss or set their exit prices.
You should set an exit price that will tell you that your trade is a losing one before the loss gets too big. Chose your stops carefully, but be aware that you can never be 100% certain that you won’t loss everything traded. This is because of gaps at the open, or limit moves in futures, and the simple fact that you can never predict a market’s movements completely. But by simply having the rules and sticking to them you will save yourself from the nasty trades that just keep on going against your position until you have lost more than you can make back with several winning trades.
It seems obvious that if you have a position that has reached you exit price, you should follow the prompts of your trading system and exit the position. Yet many traders hold on to these positions, hoping that it will turn around and make them a profit. They just don’t want to admit they made a mistake. But a trade that is a loss is hardly likely to turn around and become a winner.
Why would you want to risk any more money on a losing when you could simply close it out, accept the loss and move on? Successful traders take small losses, and let their profits run. Keeping the losses small conserves their capital, and it also frees the capital from being held losing trades, allowing it to be put to work making you more profits.