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How to Cut Your Losses Short?

 

If you are trading in the share market and you wish to reduce your losses and increase your profits then, how to do it? Michael Marcus, a successful trader says, “To become a successful trader, the most important rule is to hold on to your winners and cut your losers. Both are equally important. If you don’t stay with your winners, you are not going to be able to pay for the losers.” Simply put, it means to cut that trade short where you face losses and hold on to that trade where you are making profits. In this manner, you’ll be able to earn good profits.

 

Similarly, British Political Economist David Riccardo says, “Cut short your losses and let your profits run”, which means short your losses in time and hold on to your profits. So what concept should we follow for this? This concept is followed by all the successful traders world-wide. It is known as ‘Stop-loss.’

 

What is Stop-loss? Why follow Stop-loss? Where to keep Stop-loss? All these concepts will be explained in detail in this blog post. For first time investors, there is always a fear in their mind while investing in the share market that if for example, I invest in a share of a company in the market and later the market collapses and the share in which he invested goes down to Rs. 0 then?

 

So, after we’ve invested in a particular share and later the market collapses and are investment also goes down with it then we should not wait until it gets swiped out of the market. Instead, we should plan in advance that if our prediction goes wrong, we will exit at a particular point.

 

Most of the times it happens that investors time their entry point but have no clue when to exit from the market. In this regard, a famous trader and hedge fund manager Bruce Kovner quoted, “Whenever I enter a position, I have a pre-determined stop. That is the only way I can sleep. I know where I am getting out before I get in. The position size on a trade is determined by the stop, and the stop is determined on a technical basis.” In simple terms it means, whenever he trades, he already predetermines that if his prediction goes wrong he will exit at a particular level which is known as Stop-loss.

 

So if we wish to become a successful trader, even we should decide that if the investment decision we had planned goes wrong then at what level should we accept the loss and exit? To have knowledge of this is very important. This is known as Stop-loss.

 

Let’s take an example. Consider you are buying a share at Rs. 100. Along with the planning in mind that if the share price falls to Rs. 90, you’ll exit. Deciding this will help you to limit your loss up to a specific mark. So now your loss will be limited to Rs. 10 per share only. In case the share price goes down miserably, you’ll be at no additional risk since you excited as you planned. In this way, Rs. 90 is acting here as a Stop-loss.

 

In many cases, traders don’t follow this rule of Stop-loss thinking that if they purchase a share at Rs. 100 and then the share goes down to Rs. 90 and if again the share rises, they might miss the opportunity to earn good returns.

 

If the share price falls down and you exit and later if the share price rises, it will be your misfortune. But it is still favorable, because if that share after reaching Rs. 90 would have gone further down then you might have had to face huge losses. Thus, it’s better to risk a little than to lose it all. Another reason for following a stop-loss is that if the share price after falling down to Rs. 90, goes up again, you can purchase the share again.

 

In respect to this, the famous trader Paul Tudor Jones says, “Whenever you are in losing or uncomfortable position, you should exit that trade. And if the position reverses, you can always get back-in” If the share price goes up again, you can always purchase the share again.

 

Most of the traders feel they are frequently meeting stop-loss. The reason behind this is that they maintain a too tight stop-loss to limit their loss.

 

In this case, if you are purchasing a share at Rs. 100 and keep your stop-loss at Rs. 99, chances are you’ll most often meet your stop-loss then. This should be avoided. Understand, you are buying a share not rocket which moves in one single direction. We are trading in the share market, so fluctuations are bound to happen. So we should not maintain such tight stop-losses.

 

If you wish to become a successful trader by carrying out short-term and medium-term trading then here the fluctuations that take place are mostly primarily price-driven. Also, the fluctuations occur due to news as well as emotions/sentiments of people.

 

For this purpose, while carrying out short-term and medium-term trading it is very important to have knowledge about the price pattern, charts as well as technical analysis and talking about the long-term, the price of shares of a company follows the company’s core fundamentals. Hence, for long-term investment, it is important to know about the fundamental analysis of the company, in order to become a successful trader.

 

The famous trader Bruce Kovner whose net worth in 2019 is approx. 530 crores USD says, “If you wish to build your fortune by way of trading then it is very important to understand the share chart. If you are trading without referring to the share chart then it would seem like you being an orthopedic surgeon are treating the patient w/o referring to his X-ray.”

 

So if you’re trading in a share w/o referring to the share chart and if that share is moving in a limited range then it is quite possible that due to moving in a limited range, whenever you place a stop-loss, the share hits this stop-loss. And hence, whenever you try to buy the share, its price falls down and whenever you try to sell the share, its price goes up as share is moving in a limited range. Thus, it’s important to know how the share is trading.

 

How do professional traders do it? Let us understand with the help of a simple example.

Nicolas Darvas, an Hungarian dancer who made $ 2 million by just investing $ 33,000 while trading, he used to first find such a share which used to move in a limited range in a box and then as soon as it got out of that box, he used to buy it and while doing so, he used to set a stop-loss in that box. So whenever that share used to hit the stop-loss he would exit that trade.

 

Let us see a simple example. The share of Lorillard displayed a good growth earlier moving from $ 7 to $ 27. Later, on it started moving in a limited range i.e. a box from $ 24 to $ 27. So as soon as the share jumped out of this box, Nicolas bought the share and kept a stop-loss of $ 26 in the box. What happened here was that before going up the share went down and hit the stop-loss and then again went up. So after the share went up again, Nicolas felt it was signal of an uptrend and bought the share again by setting a new stop-loss again at $ 26. Later, Nicolas earned a good profit in this trade.

 

Now we’ll try to understand the secret these professional and successful traders follow, by way of which they limit their losses and long their profits. Let us learn this secret technique. When the shares of the Lorillard Company displayed an uptrend, Nicolas Darvas too kept changing the levels of his stop-loss as per the upward movement of the share. As the share grew, the level of stop-loss increased as well.

 

Remember, share moves up and down in a pattern. So the level below which the share does not fall is known as Support according to technical analysis. So as the share value increased along with forming new increased levels of support similarly, Nicolas increased the levels of stop-loss and set stop-loss accordingly below the level of these newly formed supports. Thus, when the shares of the Lorillard tried to break the support, Nicolas exited the trades and hence, using this technique made good profits. In this way, by managing the levels of stop-loss, Nicolas made good profits in such trades. With respect to this Nicolas said, “Not maintaining a stop-loss while trading is similar to living in an apartment w/o fire safety equipment.

 

India’s most successful investor and trader Rakesh Jhunjhunwala says, “While trading, analyzing the trend i.e. carrying out the technical analysis is very necessary.” He says out of 100 trades, he can be possible right in 40% of the trades whereas, people feel if they trade then 100 out of 100 trades should be right.

 

How to make a good profit by being right in 40% of the trades? Here, famous Wall Street Investor and billionaire George Soros says, “While trading it does not matter how many times you went right or how many times you went wrong, what matters is how much money you made while you were right and how much money you lost while you were wrong.”

 

Hence, it is very important to follow Stop-losses in trading and using appropriate Stop-losses in the share market. As the famous saying in the stock market goes, “Cut your losses short and let your profits run.” It means exit early while you’re running into loss and have patience while you’re incurring profits. This way you’ll lose less and earn more.

 

Happy Trading, Happy Investing!!!

 

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Video links:

Stop-loss - https://www.youtube.com/watch?v=Tht7n2v0vRs

Nicolas Darvas - https://www.youtube.com/watch?v=njCUgpWXg4Q

 

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