Don’t Cut Your Losses!

We all know that Warren Buffet is quoted as saying “Don’t Lose Money!”. And that most seasoned traders laugh at the fact that many novice investors avoid losing money simply by holding on to losing positions until (hopefully) they recover; thereby never registering their “paper losses” as real losses… until it’s too late.

I used to laugh at those people, too, and I would have been one of the first to agree with Robbie Burns (aka. The Naked Trader) that you should “Cut Your Losses While You Can“. But now I’m not so sure.

Suppose a particular banking stock has fallen in price from a lofty 1000p-per-share to a lowly 100p-per-share (or worse), as many had done in the not-too-distant past. You might decide to invest a modest £1000 in the hope of an eventual £10,000 reward for your £1,000 risk. If you’re willing to accept those odds (who wouldn’t?) then there is really little point in crystallising your loss by closing your position when the value of your “investment” falls from £1000 to £750 or even £500.

Note that it’s different if you invested £100,000 in this same banking stock when it was priced at an all-time-high 1000p-per-share and your life savings are now ebbing away. But why the hell did you take that trade in the first place?

Anyway, if I’m happy to hold onto losing positions in the hope of an eventual recovery, where does this leave my fondness for stop orders? Well, I’ve often said that they are just as useful for freeing up margin (in a spread betting account) or for “locking in” profits as they are for stopping losses.

If your £1000 investment in Big Bank plc (not a real bank) grows to £1,500, feel free to apply a stop order that will take you out of position with at least £250 worth profit… but which nonetheless allows your position some wriggle-room to continue appreciating.

The new golden rule is: don’t ever exit a position at a loss! long as a total wipe-out (i.e. the company goes bust) won’t wipe you out, which is where sound money management, prudent position sizing, and diversification come in. Incidentally, those are features of my position trading approach.
Never exiting a position at a loss doesn’t mean cashing in your chips at the first sign of a profit, because we have to run those profits. What’s the point in taking a 10:1 reward:risk trade if you never realise the 10x upside… or anything like it?

Now, exiting your positions always for a profit is easier said than done, even when you have stop orders locking-in those profits. Market meltdowns and price slippage can conspire to render your stop orders ineffectual, which is why I’m a big fan of the guaranteed stop orders provided by IG; even better, the retrospective guarantees offered by InterTrader and Capital Spreads.

Unfortunately, some spread betting companies and most if not all conventional stockbrokers, don’t offer guaranteed stop orders. But some of them offer something similar in the form of “stop-with-limit” or “boundary” orders whereby you are assured to stop out within your specified range… or not at all. They don’t guarantee an exit at a known profit, but they can guarantee that you won’t be taken “out of position” at a loss… providing you’re happy for that loss to remain a “paper loss” until such time as the price recovers again.

The bottom line: If you only ever exit positions for a profit, and never at a loss, you will surely make money! If only it were that simple.

Two Steps to Better Spread Betting:

1) Buy the Better Spread Betting Book
2) Sign up with Capital Spreads, IG, ETX Capital, or Spread Co

Disclaimer: this posting is for general education only; it is not trading advice.