When to cut losses on a stock trade is one of the most important decisions to make about about a trade, yet it's often overlooked because most new traders are unsure of how to come up with a risk level. The goal of this post is to cover what you should take into consideration while managing risk and cutting losses on a trade.
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If you think that you don't need to focus much on cutting losses and can simply hold until the stock bounces back... the market has just yet to humble you!
That trading style is how you end up "bag holding." A bag holder is someone that holds onto a loss for as long as it takes for the stock to bounce back enough for them to get out at breakeven or even a profit. However, they don't always bounce back so bag holding is not a trading style used by successful, consistently profitable traders. Even when the stock does bounce back and the trader gets to exit at breakeven instead of taking a loss, you should still consider how much opportunity was lost while the money was tied up in a losing position! Simply put, when you're bag holding you can't put your money to work in the market on better trade setups and miss out of potential profits.
So how do you avoid this? Simple. Cut losses! I know... easier said than done, but it's crucial for long-term success in the market. You have to just "rip the bandaid off" and move on from the long trade. After all, even the best of the best don't trade with 100% accuracy.
The price level you use to cut your losses is actually something you should know of before even entering the trade. This risk level should be part of your trade plan and can be found using some very basic technical analysis. One of the key point made when talking about a level of support is the fact that if a stock breaks below support, it is likely to continue lower until new support is met or formed (assuming it's not a false breakdown). For that reason, you can use a level of support not only to buy in hopes that the stock will once again bounce from that price, but also as a risk level in case it does not.
Before setting your risk level to cut losses directly at nearest support level though, keep in mind the possibility of the stock returning to support or even very briefly dipping slightly below support before bouncing back up. In that case, you would end up cutting losses at the worst possible time and would be taking an unnecessary loss. To avoid that from happening, try setting your risk level somewhere between 2% and 8% below the nearest support. I know that's a fairly large range, but it really depends on your personal risk tolerance and the volatility of the individual stock that you're trading.
For example, you may want to give a highly volatile small cap stock a bit more wiggle room before cutting losses than a less volatile blue chip stock to avoid getting faked out. You can then use this risk level level to figure out your ideal position size as well. if you happen to be trading a more volatile stock and decide to set you risk level 6% below support, you'd probably be better off buying a smaller position than if you were only risking 2% below support with a more stable stock.
All of these factors should really be tied together and should be a part of your trade plan that you create before you even open your position. By having a trade plan and knowing exactly what to do when the stock reaches a certain price, you can take a lot of the emotion out of your trading and focus on the price action and your strategy!
This is a huge advantage because being able to control your emotions while trading is one of the most difficult aspects of successful trading. If this is something that you struggle with, you may want to consider trying different order types to automatically cut losses for your, rather than having to manually sell your shares once the stock falls to your risk level. There are three main types of stop-loss order that will do this for you.
1. Stop on Quote: A stop on quote order will turn into a market order to sell your shares immediately when your selected price level is hit. For example, you set a stop on quote order at $1.79, the price falls to $1.79, and your shares are sold at the market. This means that you may not be able to sell all of your shares at $1.79 if there aren't a sufficient amount of share being bought at $1.79. In that case, the rest of your share may be sold at $1.78, $1.77, $1.76, etc.
2. Stop Limit on Quote: This order type type is almost identical to the stop on quote order. The only difference is that this becomes a limit order o sell your share once your price level is hit, rather than a market order. For example, you could set a quote price of $2.00 and a limit price of $1.98. In this case, if the stock price fell to $2.00 and activated your limit order, you know that your shares will be sold for at least $1.98 (if not higher). If this was a market order, you could end up selling some at $1.97, $1.96, $1.95, etc. The only downfall of a stop limit on quote order is the fact that you may not be able to sell all of your shares at your selected limited price if there isn't volume at that price to purchase your shares. For that reason, it's fairly important to give your limit order some space, rather than setting it directly below the quote price that will activate it.
3. Trailing % Stop on Quote: This order type is meant to protect your profits on a trade and keep you from allowing a winning trade to turn into a losing trade. With this order type you have to select a % in which you want the stock price to be trailed. If you were to put 5% and the stock went directly down after you bought, this order would turn to a stop on quote order and sell your shares at the market once the price went down 5%. However, if the stock first went up 5% before coming down 5%, you would be selling at breakeven, because the order trailed the price of the stock when it initially went up 5%. Personally, I never use this order type and recommend most traders to stick to a basic stop order to cut losses if they choose not to do it manually, because you almost have to set your trailing stop at the perfect percentage in order to really take advantage of it and not get stopped out on the stock's dips and pullbacks.
Regardless of the order type used, what's most important is that you're actively cutting losses when need be! Hopefully this post emphasizes the importance of managing risk and gave you some ideas of how you can properly do so.
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