How to Limit Your Losses

March 3, 2016 |

After trading for a number of years, I have slowly constructed a sound methodology that has helped me trade with more safety and to limit losses. In a short series that I am guest-authoring for the Stock Rover blog, I will share several of the lessons I’ve learned. Today I want to focus on the two strategies I use to make sure I don’t lose too much money on any one holding. In future posts, I will discuss options and screening criteria I use in stock picking.

Before diving into my core investing principles, I would like to point out that I believe that becoming wealthy has never been easier in America thanks to technology, quantitative easing, bull market in stocks / real estate, and vast resources such as Stock Rover available to help us make more intelligent decisions.

Two Strategies for Limiting Your Losses

Warren Buffett is famous for saying “There are two rules of investing. Rule #1 – Don’t lose money. Rule #2 – Never forget Rule #1.” Easier said than done, perhaps, but below I will share what I have learned as an investor that has helped me structure my portfolio to let profits run and cut losses short. These help put the probabilities of trading on my side.

The best way to limit losses is to use a “stop loss” order. A stop is the downward limit you set for a security. Simply put, a stop loss is a predetermined price at which you will sell shares, regardless of anything else happening with the company or in the market.

There are two types of stop losses – a simple stop loss and a trailing stop loss. A simple stop does not move, even if your investment moves upward. Here’s an example… Say you buy a stock for $100 and set a simple stop of 25%. This means you’ll sell the stock if the price falls 25% from $100 to $75. Even if the stock climbs to $200, your stop will remain at $75.

A trailing stop loss adjusts higher as the share price of our investment rises. This locks in profits.

For example, if you buy a stock for $100 and set a 25% trailing stop, you would sell the stock when the price falls 25% lower than $100 (down to $75). So far this is the same as a simple stop loss…

But if the stock rises to $200, your new trailing stop would be $150 (25% lower than $200). Setting $150 as the absolute floor for this position locks in a 50% gain on the position.

Is there anything magical about 25%? No. You can use any percentage. Sometimes I’ll set my stops at 40% for more volatile stocks and 15%-20% when I want to play conservatively.

With trailing stops, discipline is what matters most. Sell when you hit the trailing stop, no matter what.Following this strategy will improve your investment returns immediately.

Using a strict rule to avoid capital losses when we’re wrong removes the emotions from the trade. When we’re wrong, admitting it and taking our lumps is the most important part of trading successfully. Howard Reisman expressed this same sentiment in his When to Sell webinar.

Good investors know: Losses are part of the game, and small losses don’t matter.

Inexperienced investors 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. Nobody can survive a big loss.

Always define your losses when you initiate the position. I usually limit my capital losses to no more than 1% of my portfolio on any one trade. I do this by:

  • Keeping my position size 4%-5% of the portfolio
  • Limiting my loss with protective stop loss orders of 20%-25% on those positions

limit loss table

Thus, 4% times 25% or 5% times 20% equals only a 1% loss in my portfolio. If we make 2%-3% on the winners (of similarly small size) in 60% of our portfolio, we’ll do fine. Your winners should more than make up for your losers – as long as you keep your losses small.

In future articles we can explore how we can safely add an additional 5-12% to our portfolio by trading options and learning how to find great stocks and purchase them on sale.

Good-bye for now and happy trading!

 

Randall Bal is a professional swimmer and individual investor. Read our profile of him here.

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