One of the fundamental principals of trading stocks, or anything for that matter, is; you never play with money you cannot afford to lose. You should not be trading money needed for car payments, rent, food, diapers etc. The reason for this is, no matter how sound a system or piece of advice may sound, trades often go against you. Trading money you can afford to lose means that you have money to live, some money saved for a rainy day, and some for trading.
Now, by trading money you can afford to, or are willing to lose means just that. Even a successful trader’s account may experience dips or losses at many points. In fact, being willing to lose, or admit loss is essential to trading.
What does this mean? Willing to lose in order to win? Think of it this way. You’ve bought a stock that’s worth one hundred dollars. You’ve decided that this should and will go straight up, all the way to the moon. You’re so sure of this. In a few days the stock falls to $95 dollars. It hasn’t moved the way you expected, but you don’t sell it because you want to at least get your money back. You don’t want to live with $5 loss, because you don’t take losses. You’re a winner damn it! You check the trade a few days later and it has now slipped to $87. If you get out now you will have lost $13. Your friend says, “Hey, better ride it out.” So you ride that $87 trade down to $60. It should bounce back any minute now, right? 3 days later, we’re at $65. You’re $5 closer to getting your money back. $63, $60, $55, $40. You’ve had enough! You’re out at $38.
I don’t think this scenario is reaching too far, or reflecting on events that could never happen. The point of this story is to point out how avoiding losses actually leads to more loss. Now let’s look at this scenario another way.
You’ve bought a stock at $100. You’ve decided that you’re only willing to lose one dollar on this trade BEFORE you made the purchase. Meaning, you still expect the stock to go to the moon, but if it doesn’t, you want to get out so that you have $99 (and not $38) to make the next trade. You buy the stock for $100, and It starts to fall. It hit’s $99, and you’re out. You’ve lost! You’ve accepted it. You’ve moved on, with $99 dollars in your pocket.
Risk cannot be controlled without admitting and accepting losses. This is the only way to stay in the game to make other trades, giving you the opportunity to get some winners in the future. This of course is a simplified scenario, but the principal can be applied to many situations.
Do you have an exit strategy? How do you know when it’s time to get out of a trade? Share your thoughts with us.