Last weekend, I wrote about the importance of having a plan and in
the article, emphasized the importance of money management and exit
strategy. I just can't say it strongly enough -- money management is
absolutely critical to successful trading. No matter what anyone may
say, some losses are inevitable. The recent market reversals show how
markets can turn on a dime either up or down. Though it makes no one
happy, everyone will suffer losing trades at one time or another and
that can easily occur when the markets change direction quickly. We
should keep in mind, however, that if we manage our money properly,
losses only become a cost of doing business and do not ruin the
business, itself. In fact, as discussed in my earlier article on money
management, a trader can still make a profit overall even if more than
50% of his trades are losers so long as the money is properly managed.
If we accept the proposition that some trades will lose, we should
also understand that it is important to limit those losses. A couple of
market adages serve to underline that need: "Cut your losses and let
your profits run." "The first loss is the best loss." These sayings
have become cliche, but the fact that they are so well known does not
mean that everyone knows how to achieve the goal. Assuming good money
management, when does a trader exit a losing position? That may be the
million dollar question. When anyone enters a trade, they are filled
with a sense of optimism about the trade. That is a natural emotion,
but it is an emotion. The fact that we enter a particular trade has
absolutely no influence on what the stock price is going to do. We'll
only continue to feel good as long as the trade goes in our direction.
What we do if it goes against us in large part determines whether we
will be successful traders or not.
Unfortunately, many people have no plan for their exit in the event
the stock direction turns against them. All too many say to themselves:
"It'll come back." Maybe it will and maybe it won't. That person has
already been wrong on the direction so what is to say that the 'it'll
come back' prediction is any better? Traders who find themselves in
this situation seem to say to themselves: "If only it gets back to 'X',
I'll sell." Ultimately, they seem to just give up and ignore the stock
or finally just get fed up and sell. Often that sale is at or near the
bottom and just before the stock turns back up. Their trading has been
governed completely by emotion and as is often the case emotional
trading dooms the trader to failure.
Traders emotion may be the most important factor in success or
failure. The trader who is able to remove most of the emotion has a
much greater chance for success than his emotion driven counterpart.
As an aside, I should mention that I believe careful study of your own
trading emotions can enhance your overall results. An excellent starting
point for this study is Dr. Alexander Elder's "Come Into My Trading
Room" (John Wiley & Sons, 2002).
One way to remove the emotion is to set an exit or exit plan before
ever entering a trade. For example, suppose you buy stock as the price
bounces up off the 50 day moving average. You could decide before
entering that you will exit if the stock turns down below the same 50
day moving average. Since the moving average line will go up as the
stock price moves up, your exit would also go up with the line. Profit
would automatically be captured until the price finally breaks beneath
the 50 day moving average. Of course, if the stock price dropped below
the line shortly after entry, you would have a loss, but it would likely
be small. The exit would be unemotional and disciplined; precisely what
we want. There are many ways to set an exit but it is absolutely
essential that the plan be in place before entry into the position.
I suggest that we understand that losses do occur in trading and
not beat ourselves up when they happen. Instead, control our losses
with disciplined money management and a disciplined exit plan.
Undoubtedly this approach will have a positive affect on our trading.
Good Trading!
Bill Kraft
Mr. Kraft's past articles are posted on our website for your review.
