Traders Should Limit Losses, Let Profits Grow

By Dr. Winton Felt

A general principle of top traders is to get rid of losers and hold on to winners until there is a sell signal (or buy signal if the position is short).  If you do not hold on to your winners, you may not be able to pay for your losers.  It is not the stocks that are gaining that should be ejected, but the stocks that are losing.  Those are the stocks that are draining asset value from your portfolio.  It is possible to have more losers than winners and still be a winner..

This writer once tested tens of thousands of trading strategies in a 3-year study that involved well over 8 hours a day of testing and analysis.  Cumulative returns were computed as each strategy was used on thousands of stocks under widely varying market conditions.  The goal was to find strategies that worked best most of the time on most stocks and that consistently outperformed a buy-and-hold strategy by at least 20% annually.  We found some, and from those we learned the characteristics of a good trading strategy.  Much of what we learned we keep to ourselves and use in our own trading.  However, it is no secret that top traders recommend that a stock be held until it actually gives a sell signal.

Our studies have shown that the best strategies sell quickly when a stock begins to decline.  In volatile markets, this can mean there will be a lot of sell signals.  A lot of the time, the signals will be false.  That is, the stock will whipsaw back to its rising trend immediately after giving a sell signal.  If you are a beginner and depending on your buying strategy, you could have a fairly even distribution of small gains and small losses in a volatile market.  However, when you add in the cost of commissions, you may find that the amount of money lost in the transaction is greater than the amount gained.  This is not always true, and whether it is or not depends on the strategy used.

To address this issue, you can put a cap on how much you can lose on a trade but remove the cap on how much you can gain.  Though we do not recommend that a trader use a straight percentage for stop losses, we will use one to illustrate our point.  Let's assume that you have decided to sell any stock that drops 3% below the highest low price reached by the stock since its purchase.  If the low rises at all, the loss on a sale will be less than 3%.  Once the low rises more than 3% above your purchase price, being stopped out of the position will result in a gain.  Now, sometimes the stock will rise 20% or more before it declines 3%.  Therefore, the amount you can gain from a position is not limited, but the amount that you can lose is quite limited.  By getting occasional big gains, you can more than pay for the little losses and the commissions.  

There are exceptions, of course, and our own traders at stockdisciplines.com will sometimes sell before there is a clear sell signal.  They have traded a long time and know what they are doing.  However, the beginner sometimes thinks that, "you can't lose money if you sell when you are ahead."  This perception can easily lead to disaster.  It does not reflect the realities of the market.  No trader can always be money ahead when he sells.  If he tries to make a practice of doing so, he will tend to sell long before he has captured the full benefit of the position.  If he thinks he can always hold until he is ahead, he would be better off not trading at all.  Such people really do not belong in the market.  If they do not leave voluntarily, the market will drive them out by taking away all their money.  Expert traders are flexible.  They expect the market to twist and turn, and they adapt quickly.  Losing is part of the process and it must be accepted as part of the cost of doing business.  The important thing is to develop strategies that will enable you to accumulate greater gains than losses.