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It is every investor’s hope 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, nobody is right all the time.
However, with the right investment strategy, you can still come out on top when you take losses with some of your stocks. If you follow the rules, you do not need always to buy at the bottom and sell at the top to make consistent gains.
Let’s check out the math. If you cut your investment losses at 7 to 10% and let your winners run so that you can take your profits at 30, 50, or even 100% you will keep your portfolio ahead of the game.
After first purchasing a stock, it is tempting for investors to believe that the drop in price (below purchase price) may be temporary or just a small blip in a volatile market. It may also mean a continuing downward trend in a stock that is in trouble. Very occasionally a glamor stock may be built on speculation and hyperbole but in reality has very little substance. This situation was prevalent during the tech boom. Some investors suffered huge losses while awaiting the turnaround to occur. In many instances this never occurred.
Cutting losses by means of stops is a difficult strategy to adhere to. This is because investors tend to get somewhat emotional (even though they deny this) about their shares. They become attached to the particular company and optimistically that things must improve for the company. They don’t sell these stocks until they have already lost a bucketful of cash.
Cutting your losses is the absolutely the best defensive strategy any investor can have. When you manage your stocks successfully, and watch the market trends regularly, you can quickly observe when a stock starts losing money. It may only be a little bit now and then but when a real downward trend becomes apparent this is when the situation must be dealt with. Using automated stop losses can be a huge help to offset the psychological difficulties of selling your losing trades.
When you see the stock fall, say, 7 to 10% below its purchase price you should be prepared to sell that stock immediately – if you’ve set an automatic stop loss, it should automatically occur once the trigger level is breached. If you stick with that stock until it falls 25%, you have to see a 33% rebound before you get back to even. If you miss this point, and the stock falls 50% you have to gain 100% rebound before you break even.
If you buy a stock at $1 per share and it falls to 90 cents, get rid of it fast. Show some discipline and commitment to your strategy. Sometimes the stock you sell may subsequently rebound. Then you may have regrets about selling.
Conversely, if you buy a stock and it rises 10%, lock in that profit by being prepared to sell that stock at a drop of 5% from its high, thus retaining 5% gain. If it rises 25%, be prepared to sell the stock if it falls just 5%.
You may have a plan to sell anyway when your stock achieves a 25% gain. There is no reason not to stick to this plan. By adjusting your selling plans so that you can lock in profits, you will avoid the situation where your stock which has seen a meteoric rise may then have a similar disastrous fall, wiping any gains you may have achieved.
Sensibly applied this technique will help you avoid big losses and also enable you to lock in good profits.
Initially, a selling stop of 7 to 10% means that the investor can ride out any short term fluctuations in the market. However, you can also use stop losses to to help you hang onto your gains. This technique is called a trailing stop loss. You may say to yourself that once a stock on which you’ve made a significant paper profit drops by 5% you will sell. Every day after the market close you adjust the stop loss so that it is always 5% lower than the closing price for the day.
The essential rule is that you must never lower your stop loss. As soon as you drop the stop loss it has lost all relevance as a trading discipline. Of course, if the stock continues to rise so will must the stop loss – a certain degree of adjustment will be required, often on a daily basis. However, at some stage, 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 every has ever lost money by taking profits, many investors will have seen unrealized paper gains evaporate as the recent downturn mauled their stock values. In volatile times, stop losses can be a very useful tool for the investor to preserve capital but also to preserve profit in your most successful trades.