Editor's note: Today, we're continuing our series on the big differences between average investors and professional speculators... by looking at one simple practice that will limit your losses and maximize your gains...
Wednesday, May 27, 2015
Plan the trade and trade the plan...
This old piece of trader wisdom may sound like common sense.
But following this one simple idea will put you ahead of almost every other investor or trader in the world...
While investors put money to work over a long time frame, speculators seek out returns of hundreds of percent a year. They buy stocks with the goal of selling them to other people at higher prices.
Now, this might sound risky. But the art of professional speculation is the process of reducing risk. It's about risking small amounts of money to make large amounts of money.
So how do professional speculators limit their risk? By always having a clear plan on how to exit a trade.
If you don't have solid plans for exiting trades, it's like driving a car with no brakes. You're running an incomplete machine... and you're headed for disaster.
The amateur investor or trader is usually 100% focused on his entry. He's always focused on the potential gains he can make. He doesn't think for one second what the plan will be after he enters the trade. If things don't go his way, he has no plan... he simply reacts emotionally and makes money-losing decisions.
That's not what professional speculators do. We have an exit plan for every position we take.
An intelligent set of exit strategies answers questions like:
An intelligent set of exit strategies also allows you to mind the most important rule in all of speculation... which is to make sure to win a lot when you're right... and lose a little when you're wrong.
You see, while it's important to have an exit strategy for cutting losing trades short, it's also important to have exit strategies that help you make the most of winning trades.
You don't want to suffer a "round trip," which is when a stock you buy doubles or triples in value... and then plummets all the way back to your entry price... leaving you with nothing. Profit-taking exit strategies turn paper profits into cash profits.
Remember... you spend your "gains." All the green numbers in your online brokerage account can turn red in a hurry. You only make real money when you sell. Professional speculators are always thinking about how and when to get out of the stocks they own.
There are numerous exit strategies you can put into place. You can choose to sell based on bad news about a company, on an acquisition announcement, or after a stock has made a big run higher. But one of the most important exit strategies is the stop loss.
This is the most important one because it's about constraining losses and preserving capital.
In my Professional Speculator newsletter, we use the "hard" stop loss. The hard stop loss is a percentage based on what you paid for your stock or investment.
Say you buy a stock for $10 and you set a hard stop loss at 40%. That means when your stock hits $6 based on closing prices, you sell your stock. No questions asked. Case closed.
A hard stop loss is easy to calculate, follow, and use. You don't have to keep updating it or track what the new price is from day to day. It can also prevent you from getting out of positions too early.
In Professional Speculator, we generally follow a hard stop loss of 35%. This ensures our losing trades won't cause significant harm to our portfolio... and it gives us enough room to keep our positions through temporary price swings. For example, investors following other loss-containment strategies might be easily shaken out of their positions when hedge funds and traders at investment banks try to manipulate stock prices.
But no matter what your exit strategy is, make sure you have one. It'll help you keep your losses small and allow you to maximize your gains.
If you're like most people, you have trouble deciding when to take some money off the table. As Dr. David Eifrig says, "The strategy for selling is determined by why you bought in the first place." Learn how "Doc" plans his trades here: Before You Sell a Single Share of Stock, Read This.
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