Profitable Trading - Part 3 of 5
May 12th, 2008 by Erv
Always use protective stops! This is an absolutely imperative action you must take! It is also the way to limit our risk as per Part 2 of this discussion. Once you’ve defined your 2% risk in terms of your account equity, always place a protective sell stop to get out of that trade at a maximum 2% loss, no matter what.
You can always get back in. You can always trade another market. There is always another opportunity. But if you don’t religiously use stops to limit your risk to 2%, it is almost a certainty that you will never make any money on a consistent basis.
You might get lucky once in a while by not using stops. But be assured, without a hard and fast rule of using stops, you will give back any “lucky” profits you make in no time, guaranteed. I have experienced this myself many times (OK, so I’m a slow learner). Back in the 2000 tech stock crash, I let the biggest profit I ever had to that point become my biggest loss ever when I removed a stop from Cisco. It was at $76 or so and started dropping. I had a stop at $66. As Cisco’s price approached $66, I decided I didn’t want to sell it so I removed the stop (and, afterall, this was a “healthy correction” as Cisco could never go anywhere but up over the long run, right?).
If I remember correctly, the price dropped to about $65 then reversed and headed back up to $73. I congratulated myself for such a “smart” trading move. I eventually sold Cisco for around $10/share three years after the crash (and, of course, that was about the bottom and a year or so later Cisco was at $25, but that’s the way it goes when you ignore the rules and try to outsmart the market).
The above information applies to stock trades. If you are trading options, using stops (and the 2% rule) is not practical. But as long as you are only purchasing calls or puts, you can implement similar risk-controlling measures by never buying an option position that equates to more than 2% of your account’s total equity.
There is another important factor to remember. To learn what it is, tune in at some randomly selected time in the future for “Profitable Trading - Part 4 of 5″.
