Managing Risk and Cutting Losses
What’s a discussion on trading without talking about risk management? And when talking about risk management, the discussion naturally leads to using stop losses (i.e., an automatic order to sell (or buy) a stock at a set price). Stops are typically used to limit losses to a predetermined amount. They can also be used to lock in gains. In this chapter, we focus on the use of stops to limit one’s losses.
First, let me say that all of the performances from all of the different strategies that we’ve looked at so far have all been done without the use of stop losses or any other type of risk management or money management rules.
And I think this shows just how solid some of these strategies are. Nonetheless, stop losses can be very useful, so let’s take a closer look.
Using Stop Losses
Nobody ruins their portfolio when the market is going straight up. It’s when the market goes down that people get into real trouble.
But ironically, it’s when the market is going up that a lot of these bad habits are created. The problem is that even bad decisions are oftentimes rewarded in a bull market. But when the market is going down, there’s no mercy for bad decision makers. Sitting on losses in hopes of them coming back can ruin your portfolio as they grow bigger.
And that’s where stops come in. Some people don’t use stops at all. Others, however, use very close stops, or tight stops as they’re called. I’m not a fan of overly tight stops. You don’t ...