Assuming that we don’t know anything about the stock market we are faced with a simple choice – buy a stock or don’t buy a stock.
You’re probably reading this book because you want to know more about investing so let’s assume that you choose to get involved and buy a stock. There are two things that can happen.
A – The stock can go up
B – The stock can go down
In other words, it’s a 50/50 bet. We have an even chance that the stock could go either way.
For the moment we aren’t really worried about picking winning stocks because we want to focus on the idea of money management.
As we discussed earlier, money management is about protecting your initial investment while limiting your losses and making the most of profits.
So let’s go back to our 50% chance. If we were to go about buying stocks on this basis, we could reasonably expect to make no money. It would be like betting on the toss of a coin. On average half our shares would be winners and the other half would be losers.
Without knowing more about the stocks, what could we possibly do to improve our results?
One solution would be to pick better stocks so we have more winners and fewer losers.
Yes, this will work, and we’ll discuss that later, but for the moment let’s assume that we have no way of working out which are the better stocks. Therefore, we need a different way to improve our results.
The answer is cutting the losers.
In order to do this, we’ll need to say that if the market moves against us we’ll get out and if it goes up we’ll keep it.
It sounds simple – but it works.
Imagine that we take 10 trades. Let’s say that in 5 trades the stock goes up and in 5 trades the stock goes down.
We can make a rule in your system that says if a stock goes down more than 5% after we have bought it, we’ll sell it and take the 5% loss.
On the other hand, if the stock goes up, we will hold onto it until it goes up 10% and then sell it.
Using these rules, and assuming we are spending $1,000 on each security, our results are as follows:
5 Trades x 5% Loss ($50) = Total Loss of $250
5 Trades x 10% Profit ($100) = Total Profit of $500
Therefore, by using a simple money management technique the total result from our 10 trades is a profit of $250 even if we only have a 50% chance of winning. So remember to add a rule to your trading plan that cuts off your losing trades and makes them little losses before they turn into big losses.
What About “Stops”
Experiencing your first major loss can be very stressful. For most people the money is hard earned and so protecting your investment capital is very important.
One way of minimising the losses is by setting “stops”.
The point where you place your stop depends on the level of risk you are prepared to take and the amount of investment capital you are prepared to lose.
In this situation, you are setting a “stop loss”, because it is placed on the downside of the share price and is designed to stop you from losing too much money.
Placing Stops
Learning to place stops is like learning to drive defensively. Just like putting on a seatbelt as soon as you’re behind the wheel, you should always set stops the moment you enter a trade. As time passes, stops need to be adjusted to reduce the amount of money at risk and to protect a bigger chunk of profit. But you should only ever move your stops upwards.
In some markets you can tell your broker in advance where your stop is and if the market trades at that level, they will automatically execute the stop for you. In other markets, you will need to record the stop yourself and contact your broker to let them know to close your position.
Follow along with our two traders Nev and Mick and see a practical example of how Mick uses a stop loss to cut his losses short and protect his capital.