A stop loss is a pre-determined price that we use as the trigger to sell out of a losing trade. If the share price falls instead of rising then we sell and we sell at a pre-determined price to ensure that we minimise losses. We need to have a stop loss price because not all trades succeed – some fail. Even the best trading techniques struggle to deliver a success rate of more than 70%. Therefore even using some of the best trading techniques we will still end up with two or three losing trades out of every ten. For these losing trades we must keep our losses really really small.
Another way of thinking about share trading is that any trade can only have one of five possible outcomes:
A small profit.
A large profit.
A small loss.
A small profit.
A small loss.
That’s it. Five possible outcomes, no more, no less. If you could eliminate one of these five outcomes, which one would you choose? That’s right – the large loss. If you eliminate the large loss you are only left with the other four possible outcomes. If our small losses, breakeven trades and small profits even out over a period of time you will only be left with the occasional large profit, a rather pleasing outcome.
By now you should be in no doubt about the wisdom of eliminating large losses. The Stop Loss is what we use in every trade in order to eliminate any large losses.
We use a Stop Loss Rule. The stop loss rule has three parts to it:
1. With every single trade that you do you must have a Stop Loss in place.
2. Your Stop Loss price is set at the level where your loss will be 2% of total trading capital.
3. When your Stop Loss price is hit then you must sell. No ifs, no buts, no maybes. No waiting one more day/week/month/year until your trade turns into a “long term investment”.
For those who may be new to share trading the most difficult part of this rule is part 3. You must sell when your stop loss price is hit. It’s the most difficult part of the rule because it brings into play your emotions. Despite the huge emotional drag not to sell – you must sell. When your stop loss price is hit then you sell, no scond guessing. Following this simple and straight forward rule protects your hard earned cash.
