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What's the
Risk?
A
primary reason why short-term trading is “politically incorrect”
is the consideration of risk. Some even categorize trading
as some type of social derangement like compulsive gambling
and other addictions.
In fairness to those who oppose
the idea of trading, one can barely bring up the subject without
hearing stories of the online trading junkie who day-traded
away his home, possessions and family.
In truth, stock trading is
like anything else that requires the utmost skill and discipline
to succeed. In the hands of an experienced surgeon, organ
transplants are nearly always successful; in the hands of
an amateur, attempting such an operation would be sure disaster.
"Minimizing losses,
as a sound strategy, is not limited to trading.
Even long-term investors should learn this rule
to maximize their portfolio. Why should one suffer
through agonizing corrections, even when holding
for the long term?"
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Stock trading can be incredibly
successful even in “bad” markets as long as the following
three rules are strictly followed:
- Know how to select probable winners.
- Minimize losses.
- Maximize winnings.
Rule #1 is obvious. By “probable
winners” is meant selecting stocks that have at least a 50%
chance of moving in a favorable direction, and moving in that
direction in the immediate future.
Rule #2, while also obvious,
is probably the most common reason anyone loses money trading.
Assuming at least 50% of one’s trades are successful, the
only way to make money is to cut losses short and cut them
quickly.
I am so strict about this
rule that I tend to error on the side of bailing too soon
on a stock. If a trade doesn’t go my way almost immediately,
I’m out. As a general rule, I limit my losses on a single
trade to a maximum of 5%. Since many winners will produce
better gains than 5%, significant gains can occur by being
“right” only half of the time.
Minimizing losses, as a sound
strategy, is not limited to trading. Even long-term investors
should learn this rule to maximize their portfolio. Why should
one suffer through agonizing corrections, even when holding
for the long term? Successful investors will tell you to never
allow a stock to drop 7-10% of your buy price, ever. People
that don’t follow this rule will often produce very low gains,
if any.
Rule #3 is probably the least
obvious and is often overlooked by traders, especially day
traders. There is even a saying in trading circles, “No one
ever lost taking a profit.” Nothing could be further from
the truth!
Simple arithmetic will show
that if your profits don’t run ahead of your losses, the net
gain is negative. That’s why you have to cut your losses short,
but it is also why you must let your profits run higher than
that (in reverse). If you always bail on a trade that loses
5% you had better ride your winners to at least 6% or better.
A more accurate philosophy might be, "No one ever lost
money taking profits greater than their losses."
How does one maximize profits?
There are entire chapters written in books on this subject,
but my favorite technique is to follow a winning trade with
progressive stops.
For instance, let’s say a
$20 stock rallies to $22 (a gain of 10%). As tempting as it
may be to just sell for a cool 10% gain, I will often place
a stop-loss sale at price slightly below $22, say $21.50.
Then if the stock continues its rally I will move my stop-loss
price up accordingly. In this way, I am virtually guaranteed
a fat profit even if my first stop-loss is tripped; yet I
am giving the stock a chance to produce a much greater return.
How many times have you sold
a winning stock only to see it rally to far greater heights?
By using a similar stop-loss system you will often catch these
rallies when you would have otherwise sold too soon.
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