Stop Losses

Poor traders see every loss as a failure. But small losses aren't failures. They are victories – victories against big losses. You must avoid big losses at all costs. Few can survive a big loss.

Good traders know this: Losses are part of the game, and small losses don't matter.

As a trader, having an exit strategy is vital to your success. If you stick to your exit strategy, it can serve as a near-foolproof way to methodically cut your losses and let your winners ride.

One of the best exit strategies is to set stop losses. These are set prices or percentages you use to know exactly when to sell.

There are two types of stop losses: hard stops and trailing stops.

Hard stops are based on a set price or percentage below the purchase price. If the stock falls to that amount at any time, you sell.

Let's say you go long X at $10 and set a 20% hard stop at $8. No matter what the price rose to for Stock X, once it fell to $8, you would sell.

Trailing stops are based on a percentage below the purchase price, but they don't stay the same. As the price rises, the trailing stop follows it.

For a trailing stop, let's say you would initially set it at 20% below your purchase price. So for X, you'd start out at $8, the same as a hard stop.

Here's the difference... As X's price rises, the trailing stop also rises. So if the stock rises to $11, the stop would rise to $8.80. If X kept going up to $15, the stop would be $12.

Trailing stops adjust only upward on a long position, and stay set on the highest price that X hits. So in this example, if X hits $15 and then goes down, you would sell at your trailing stop of $12. But suppose X falls to $12 and you sell, and then it shoots up much higher? In that case, you've still made a $2 profit ($12 – $10 purchase price), but you've forfeited any future gains.

Both strategies work well in different situations. So now you might be asking...

Using strict stop-loss rules to avoid capital losses removes emotion from the trade. When you're wrong, admit it and take your lumps. It's one of the most important rules to successful trading.

Remember, before you trade, know exactly why you're buying or selling. Set yourself up to succeed by knowing ahead of time what your exit strategy is. Stop losses are a great asset for any trader, so start using them immediately to monitor your trades.

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