Cutting Losses Short

Learning to utilize the concept of cutting losses short must be understood and used on a consistent basis to be successful at stock trading. It is also one of the hardest obstacles to overcome.

This technique is part of your Risk and Money Mangement planning. Without any price or percentage points used as some type of stop loss with each trade, you are risking being wiped out due to a catastrophic loss.

One of the biggest mistakes traders make is that they go through a period of several winning trades in a row and they become over confident.

Next, they start to use bigger position sizes and they allow the losses to become greater because they have become over confident and slack off on following their exit strategies.

Consider the following example of different traders with the same number of trades, the same winning percentage of trades and the same average gain per winning trade but who have different rules in place as to when to take a loss. I'll use a $100,000 total portfolio value to start with and a $10,000 position size on each trade for simplicity:

Trader Brad Rob Larry
% Winning
Trades
80 80 80
# of Trades 10 10 10
Average % Gain
On Winning Trades
4% 4% 4%
Average % Loss
On Losing Trades
5% 10% 20%
Ending $ Gain/Loss +$2200 +$1200 -$800

Notice that Trader Larry has the same 80 percent winning trades in his plan but he doesn't pay as good attention to cutting losses short and allows his losing trades to become larger than Brad and Rob.

You can see that even with only 2 losing trades out of 10 total trades, the end result is that Larry winds up losing money after his 10 trades are completed while Rob and Brad finish with gains due to having smaller stop losses in their trading plan.


This is only one example. In actuality, it can get a lot worse than this, read on:

Now consider the Day Trader or Scalper who has a trading account value of $25,000.00 and uses his margin account as leverage in his trading plan. With a margin account and being established as a Pattern Day Trader, this Trader, we will call them Trader Joe, can use up to $100,000.00 to trade with.

Trader Joe has 8 winning trades in a row. He has been using $25,000 per trade and has averaged a +1% gain per trade all in a weeks time. So he is now up 8%, or $2,000.00 in one week.

He becomes so confident in his system, that Monday comes along and now he uses $50,000.00 in the next trade. The trade starts to go against him and becomes a losing trade but since he had 8 winning trades in a row previously, he convinces himself that he is still right in this trade but that he got in a little too early. So instead of cutting his losses short, he doubles up on his position to reduce his per share cost of the stock.

He later watches as the stock continues to go against him, increasing the losses. Remember, now he is using $100,000 in this trade. As the loss increases, he notices that his position is closed out automatically on his screen.

What has happened is that his brokerage account was monitoring his losses accumulate just as he was, only the brokerage company has a Risk Management department of their own and they determined that his equity in the position now was too low for their risk requirements so they closed out his position. There is nothing you can do about that either, except weep.


Lets say the position got closed out with a 20% loss. Since you were using $100,000 and now have a 20% loss, that has left you with $5,000 in your account that you started with $25,000 in.

That means you lost 80% on one trade ($20,000 of $25,000) all because you became over confident and forgot about cutting losses short.

Now Trader Joe is left with $5,000 in his account, has a Margin Call due, cannot day trade because he does not have enough money in his account and has taken a severe emotional blow. Do I need to explain any more?


Okay, now you have seen two examples of not cutting losses short and hopefully you will realize by now that this is indeed something you should always use in your trading plan. Bottom line, trade smart!

Be sure to read about learning to Cut Losses Short - Trader Psychology on my other page also. The more you learn about this topic, the better off you will be in the long run.




Return From "Cutting Losses Short" To "Stock Trading Risk Management"


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