The hope of every investor is to buy at the bottom of the market and sell at the top. If this happened all the time, we would all be very happy investors.
Sadly, no one is right all the time.
However, with the correct investment strategy, you can still gain when you incur losses on some of your stocks. If you follow the rules, you don’t always need to buy at the bottom and sell at the top to make consistent profits.
Let’s take a look at the math. By cutting your investment losses by 7-10% and letting the winners run so you can take your 30, 50, or even 100% profits, you’ll keep your portfolio ahead of the game.
After buying a stock for the first time, it’s tempting for investors to believe that the drop in price (below the purchase price) may be temporary or just a minor blip in a volatile market. It can also signify a continued downtrend in a stock that is in trouble. Very occasionally, a glamorous action may build on speculation and hyperbole, but actually has very little substance. This situation prevailed during the technological boom. Some investors suffered huge losses while waiting for the change to happen. In many cases this never happened.
Cutting losses through stops is a difficult strategy to follow. This is because investors tend to get a little excited (even in denial) about their stocks. They become attached to the particular company and are optimistic that things must improve for the company. They do not sell these shares until they have already lost a large amount of cash.
Cutting your losses is absolutely the best defensive strategy any investor can have. When you manage your stocks successfully and watch market trends regularly, you can quickly see when a stock starts to lose money. It may only be a little once in a while, but when a real downtrend becomes apparent, that is when the situation should be addressed. Using automated stop losses can go a long way in offsetting the psychological difficulties of selling your losing trades.
When you see shares fall, say, 7-10% below your purchase price, you should be prepared to sell immediately; if you have set an automatic stop loss, it should happen automatically once the trigger level is exceeded. If you hold that stock until it falls 25%, you have to see a 33% bounce before you get back to par. If you miss this point and the stock falls 50%, you should get a 100% bounce before you break even.
If you buy a stock at $1 a share and it falls to 90 cents, get rid of it quickly. Show some discipline and commitment to your strategy. Sometimes the shares you sell can be later repossessed. Then you may regret selling.
Conversely, if you buy a stock and it goes up 10%, lock in that gain by preparing to sell that stock down 5% from its high, thereby retaining a 5% gain. If it goes up 25%, be prepared to sell the stock if it falls just 5%.
You may have a plan to sell anyway when your stock hits a 25% gain. There is no reason not to stick to this plan. By adjusting your selling plans so you can lock in profits, you’ll avoid the situation where your stock, which has seen a meteoric rise, can take a similar disastrous plunge, wiping out any gains you’ve made.
Applied sensibly, this technique will help you avoid big losses and will also allow you to make good profits.
Initially, a 7-10% sell stop means that the investor can ride out any short-term fluctuations in the market. However, you can also use stop losses to help you maintain your profits. This technique is called trailing stop loss. He can tell himself that once a stock he’s made a significant paper profit on drops 5%, he’ll sell it. Every day after the market closes, adjust the stop loss so that it is always 5% lower than the closing price of the day.
The essential rule is that you should never lower your stop loss. As soon as you release the stop loss, it loses all relevance as a trading discipline. Of course, if the stock continues to rise, so will the stop loss: some degree of adjustment will be required, often on a daily basis. However, at some point, once a substantial profit (for example, 50%) is made on a stock, it is better to lock in the profit with a 5% loss once the stock peaks. This technique allows you to limit your losses while letting your profits run.
Remember, while no one has ever lost money by taking profits, many investors will have seen unrealized paper gains evaporate as the recent recession hit their stock values. In volatile times, the stop loss can be a very useful tool for the investor to preserve capital, but also to preserve profits in his most successful trades.
