Importance of Stops

A ‘stop loss’ is a pre-defined level at which you will exit a position in a security based on the premise that it is not moving in the direction that you had anticipated. All experienced and successful traders will tell you that setting stop losses and then sticking to them, is absolutely essential if you are going to be profitable over the long term.

Whilst trading routinely involves decision making, there are no more important decisions you have to make than when to sell shares. Many traders often overlook this part of trading or underestimate how important that it is. It is selling that impacts directly on whether or not you make any money trading in the sharemarket, as buying shares is simply a means of putting yourself in a position to make money trading.

One of the things that separates successful traders from the majority of market participants is that they have a detailed plan that guides them when to close trades. For them, this is essential. It is fair to say that when a lot of traders buy shares they have little idea of under what conditions they would consider selling. It would also be fair to say that a fair percentage of market participants routinely adopt a ‘buy and hold’ approach.

When it comes to considering your strategy for exiting, what is important is not the manner in which you decide to exit, but the fact that you have a plan in place to advise you when to exit. What is also important is that you remain consistent in whatever approach to exiting you adopt. Selling shares is probably the most difficult decision you will face but it is the most important. The decision is especially difficult when you are faced with a loss and all you want to do is wait for the shares to return to your buying price. The situation is made worse when the shares continue to move away from you, making your loss even greater than you would have ever imagined.

There are a number of reasons why people will not sell shares when they are faced with a loss. This potentially is a problem because there will be many occasions when a trade they enter does not head in the anticipated direction. The time tested rule of ‘cutting your losses’ would be most applicable however for those who have strong self-confidence may find it difficult to close the trade at a loss because doing so acknowledges that they got the trade wrong in their own minds. This may be a difficult situation to digest so the easier option will often be to not close the trade at a loss and therefore violate probably one of the most important trading rules there are. To most traders, the idea of not closing a trade at a loss means that they haven’t had a loss despite the fact that they may have a large unrealised loss. Unfortunately for many traders, they cannot bring themselves to set stop losses or if they do, they fail to adhere to them. Cutting your losses is one of the most important trading rules there is. If you fail to cut your losses, you are most likely going to be worse off for it.