Perhaps the most basic concepts necessary to achieve profitable
trading are to cut losses and let profits run. The idea is obvious and
simple on its face, but it seems that many traders have no idea how to
accomplish either objective. In fact, I would hazard a guess that a
majority of retail traders do just the opposite. They cut profits and
let losses run. That is an almost certain road to losses and frustration.
Recently, a commentator on the blog took me to task and suggested
that I use the concept of cutting losses and letting profits run as a
tease and suggested that I write a little about exactly how to do those
things. I can only guess that he has not been following my articles for
very long and has not read my books because I have tried to deal with
the "how to" aspect many times. My coaching sessions focus specifically
on those actions as they apply to the individual with whom I am
working. Accepting all that, I, nevertheless agree with the comments
insofar as I believe it could be extremely helpful to at least some
readers to discuss specific ways to cut losses and specific ways to let
profits run. This article, therefore, is the beginning of a three part
series in which I'll try to suggest ways in which the individual can set
up his or her trading so that they do cut losses and let profits run in
ways that could work for them.
The blogger suggested it would be a cop out to say that the "how"
of cutting losses and letting profits run is an individual decision. In
that regard, I believe he is mistaken. Each of us must determine the
methodology that fits our personal risk tolerance, our goals, our
available time, our knowledge base, and the strategies we utilize and
with which we are familiar. For example, someone who only trades stocks
may have a much different loss cutting strategy than someone who trades
call ratio backspreads and someone whose primary strategy is selling
options may have a different approach than someone whose primary
strategy is buying options.
Recognizing that how we cut losses and let profits run is, indeed,
a personal decision and should be part of an individual plan, we can
still explore some of the basic concepts that we might consider applying
no matter who we are or what are strategy might be.
As many of you may know, in addition to private coaching, I have
taught a number of trading seminars over the years. In addition, I
often get calls from other traders and often speak with people who have
questions regarding trades or investments. With that background I would
suggest that it is fairly common that retail traders generally buy stock
with the hope that it goes up in price. They tend to enter positions
for a variety of reasons, and, among those reasons, may rely on
something they have read or heard on TV; they may get a tip from a
friend who already owns a stock or is about to buy it; they may act upon
a broker's suggestion; or they may have some personal knowledge gained
through research or some first hand experience. In many of those cases
they are buying a story; a story usually with some basis in
fundamentals. When they buy, they give little or no consideration to
their entry price, particularly as it might relate to an initial exit in
the event the stock turns against them right away. The entry is made
with little consideration of how much is actually at risk and with
little or no consideration of how much they are personally willing to
risk in the trade. Often these are the people who have been taught that
the only way to invest is to buy and hold and they will defend "buy and
hold" with great fervor.
In its purest form, the strategy of buy and hold generally has no
plan as to when or how to cut losses. Positions are simply to be held
no matter how much the stock drops. Any exit strategy is ordinarily
based on need or whim. The question I always ask buy and hold investors
is: "Hold until when?" I usually get a blank look. Hold until death is
certainly a strategy and one that may be wonderful for the heirs, but
maybe not so good for the investor. Using this strategy, profits may
well run and that is generally something we want to achieve, but so too
do losses. Anyone who held the likes of Lehman Bros., or Enron, or Bear
Stearns knows exactly what I am writing about. So too, albeit to a
lesser extent do longer term holders of issues of even great companies
like GE or CAT or MSFT. Of course they may "come back" and hopefully
they will. But why hold them during the downdrafts; why let big profits
turn into big losses?
If you accept my arguments so far, it only seems logical that you
would agree that the first part of cutting losses and letting profits
run is to have a plan. Using a plan, you can create a disciplined
structure in the beginning that will dictate at what point to get in and
at what point to get out. In other words you can set yourself up before
entering the position with a trigger mechanism that extricates you
relatively quickly from a losing trade and keeps you in a trade that is
winning until it turns against you. I discuss precisely how you can
create such a plan for yourself in "Trade Your Way to Wealth" and in
"Smart Investors Money Machine" . In my view, without such a plan one
has no disciplined basis upon which to cut losses and no way to make
sure profits are permitted to accumulate.
The first key is to recognize that cutting losses and letting
profits run can be instrumental in realizing success in trading and
investing. Once accepted, the next step is to create a plan for
yourself whereby you set out where and how the losses are to be cut.
That involves some system to determine the level of loss you are willing
to accept and that will be the subject of Part II of this series. Next
week, we will look at very specific ways for you to determine the
"where" of the loss cut. In addition, we'll address certain orders that
traders and investors might consider to implement the loss cut.
Once the initial level of acceptable loss is determined, we need to
structure the trade in such a way that we try to attempt to avoid
cutting profits. In part III I'll discuss specific ways a trader can
attempt to continue to capture profit while letting the play continue so
that profits that are running can continue to do so.
As these articles are published, I expect to be traveling in
Ireland so please don't expect me to respond as regularly on the blog as
I ordinarily do. Feel free to have an open civil discussion. Let me
suggest that there are many, many ways to accomplish the objectives we
are discussing here and there is probably no one perfect way. Be
tolerant and open to the suggestions of others. We always learn more
when we are willing to listen than when we try to force our own beliefs
down someone else's throat.
Good Trading!
Bill Kraft
Success Trading Group -- by Eric Aafedt
Our Success Trading service delivers quality trading ideas for the elite investor that has the financial wherewithal and market nimbleness to profit on small moves in a stock's price. Become a member and you will be provided with email and/or PDA alerts intended to provide you with the opportunity to make many, many profitable trades.
Here is a play from the Success Trading Group:
FPL Group Inc. (FPL)
Our Success Trading Group entered a new position this week in FPL Group,
Inc. (Ticker: FPL). We like FPL at its current price for a new trade
position.
Have a great weekend and we'll trade next week.
Success Trading Group Team
