What does it mean if you buy a stock, and the stock does not go up and stalls, goes sideways, or even goes down? Simply, it means that you’re most likely wrong – because you bought it to make money, and you’re not making any. And the moment you’re wrong, you have to admit that fact, then undo whatever it is you did based on that wrong judgment, and go somewhere else. Speculation in stocks is as much about swallowing your pride and focusing on making money, as it is about chart reading and other technical skills. It’s not about insisting on your opinion and losing money.
It is imperative that, when you’re wrong, you get out and go somewhere else to try again, somewhere where you might be right and will make money, and not insist that you’re right while you are losing money.
To top all this off, “Getting out” simply means cutting losses while they’re still very small – selling at a predetermined minimal loss before it has the potential to snowball into a bigger one. Take your wounded and go. Live to fight another fight. We do this by using a ‘stop loss’ order, abbreviated as ‘stop’. This is an order that executes after we buy a stock and then the price drops against our opinion – we will sell and cut the loss at:
- a small-,
- predefined distance,
- no matter what else is happening.
Stops preserve your capital
The important thing that so many get wrong is to understand that cutting your losses does not mean that you are ‘taking’ or ‘causing’ a loss. When the stock price declines to the point where your stop is, your account balance has already declined by the equivalent amount – you already have the loss. It is not a ‘temporary’ loss or a loss that will vanish if you just hold on. It is already in existence at this point – all you’re doing when the stop hits is to say ‘No more loss’.
If you buy 100 shares of a stock at $50, you forked over $5000 for the shares. If the stock price declines to $45 after you buy, your account balance (or at least the part allocated to this trade) has now dropped to $4500. That is what the shares are worth right now, i.e. you have LOST $500. This is not a discussion of whether it is a paper loss, or a temporary loss – it is a real loss, whether you convert the shares to cash, or continue to hold on.
Imagine you buy a property for investment for $500,000, and two years later the neighborhood turns bad and suddenly you can’t find a buyer for more than perhaps $375,000, matter how hard you negotiate. So, that is what it’s worth now – and you have a $125,000 loss. It is worth what anyone wants to pay for it at that time, NOT what you paid for it.
People will start arguing and justifying why they are holding on to dropping shares, believing, hoping, praying that they will rise in price again, so that it really was just a temporary loss. But there is no guarantee in the world that a stock will come back up again … and a $500 loss can turn into $2000 or more very quickly. If you are holding on the ‘hope’ or ‘expectation’ that the stock will come back, you are nothing but a gambler. The same goes for the example above with the investment property – the price might also collapse to $200,000, because now the crime rate has risen excessively. Do you know that in advance?
You can be right 4 or 5 times in a row – it only has to happen once that you are wrong and don’t cut your loss, and you can nullify cumulative profits from multiple months or years, or outright lose large money from the get-go.
Losses work geometrically against you
The nasty thing about losses is that they are not equal with gains – they grow geometrically the larger they are. That means, if you lose a given amount X, you will have to make a larger amount, >X, only to get back to where you already where. A simple calculation will shows this relationship:
Assume you put $30,000 into a single trade. The stock declines, and you now sit on a 50% loss in the trade. That is a $15,000 loss. To make back this money, using what’s left of the money, you now need to make a +100% return, i.e. double your money, to get back to $30,000 ($15,000 *2 = $30,000; $15,000 + 100%[$15,000] = $30,000) … only to get where you already were, net neutral.
That means, a 50% loss requires a 100% gain to nullify the loss – no profits made, just to break-even!
The larger the loss, the harder it is to make back – e.g. a 75% loss takes a 300% loss to get back to break-even, an 80% loss takes a whopping 400%! The relationship of geometric growth of this loss/gain relationship starts lifting off after about a 10% loss (which takes roughly 11% gain back to break-even), thus I recommend using for most trades a max. 10% loss – but we’ll get there later.
If you cut losses, you can be wrong a lot
Keeping losses small and letting winners run is the essence of risk management and profitability. In fact, all famous past and current stock speculators, all the most successful ones, the wizards and the grand-masters, without exception, are (1) wrong a lot of the time, and (2) cut their losses mercilessly. In fact, the best ones are right only in about 6 out of 10 decisions, and the average success rate is actually between 5 out of 10 to as low as only 3 out of 10.
You might wonder, how can one still make huge profits and outperform everybody else in the markets, while being wrong so often? Because as explained above, when they are wrong, they cap their losses while they are minimal, NEVER holding on and potentially snowballing small losses into large losses. They move on to greener pastures without regret, and repeat this until they are right – and then they let their profits run as far as they will go. The large profit will by a large factor outnumber even multiple small losses.
Mark and Julia
Right now, I’ll show you an example of how this works. There’s two people, let’s call them Julia and Mark.
Mark proceeds to buy any stock he likes, and holds on to his shares after buying no matter what. To him, his opinion is king. Last month, he bought three stocks – one of them went against him and dropped in price, one is lingering where he bought it and not really moving anywhere, and one brought him a profit. He does not cut losses and believes (read ‘hopes’) them to be temporary. He puts about the same amount of money in each and rides through losses. The result as you can see is break-even – not a total failure. But I am lenient here, as it assumes that the declining stock lost money slowly – which is almost never a given. As I stated above, losses work geometrically, thus the net account balance would in most cases still decline.
Now let’s look at Julia. She also bought the exact same three stocks last month. But, unlike Mark, she sells the losing position for a minimal loss when her stop is hit. Now look at the difference in the money she makes, compared to Mark.
If we assume that the second stock did not just flounder about, but actually equally declined as the first one, have a look below what happens: The third stock that makes Mark some profits becomes completely meaningless, as he suffers a net loss in his account balance from riding the losses in the first two.
Julia however only suffers a temporary setback, as she cuts losses and even despite being wrong twice in a row, she still net makes some good profits.
Even in a much more beneficial scenario, where the two last stocks both rise after buying, Mark would only make small profits due to the snowballing and geometrically growing loss in the first stock almost offsetting the profits from the two winners.
Julia however has an even stronger appreciation in her equity curve … all due to not being dogmatic and willing to say “I was wrong”.
Julia might not even be the best stock picker around, but with such a method she will easily outperform a large majority of people in the market and ensures that her capital is protected at all times. Additionally, later we will learn how Julia as a skilled speculator would pick the best stocks only, take the money out of the losing and sideways-meandering stocks and force-feed it into her winning stocks, thereby achieving even larger returns.
Meanwhile, Mark serves as a perfect example of how the vast majority of stock-pickers do not amount to much, at best achieving mediocre returns that mirror or often under-performing stock averages, and more likely than not actually losing money in the long run.
To cut or not to cut
Over time, this pans out into an interesting comparison of the account balance between those who cap losses and those who don’t. Even great stock pickers will not even out-perform the stock indices if they do not cut losses. And those who do not cut losses while picking average stocks … well, let’s just say that there’s a reason why 85% of people lose money in the markets over a long time frame.
Holding a dropping stock makes you a gambler
In the end, it is non-negotiable for you to use stop losses to become successful. It’s not that you might be wrong – you WILL be wrong, and if you can’t understand that, you might as well not put money in the markets in the first place. The simple truth is that you will never make serious money, and outperform the markets or other people if you don’t. The first job of every and any operator in any financial market is that of a risk manager and loss-cutter.
“Investors are the biggest gamblers of all. They make a bet, stay with it, and if it goes wrong, they lose it all. Speculators in stock markets have lost money. But I believe it is a safe statement that the money lost by speculation alone is small compared with the gigantic sums lost by so-called investors who have let their losing investments ride”
— Jesse Livermore
If you stick with stock that is dropping, you are a gambler, plain and simple. You are gambling that a lucky card will come up that turns everything around. But how often do these really come up? Do you want to be a gambler, or a professional?
The amateur asks “Why sell?” …
The smart pro asks “Why hold on? I am clearly wrong because I am not making money, and worse, it is going down while that stock over there is going up and I could be in it instead”.
Worse, the amateur will often indulge in what’s called averaging down, which is buying more at lower prices after they’re already at a loss. We will also cover this at later point.
The bottom line
This is your prince commandment: NEVER go in without stops.
Would you own a house in an area with high risk of fires without fire insurance, just because the chance of your house burning down and you suffering a total loss is relatively small?
It only has to happen once!
Would you take the breaks off your car and drive 150mph on the highway?
Amateurs get married to stocks and hold on to them no matter what happens. Pros date stocks, and drop them the moment they become a burden. What’s tragic for romance, is the key to out-performance in the market.
Now that we’ve covered loss cutting, let’s go back to our original train of thought. With this knowledge, we will in the next guide discuss why we can’t buy a stock that we find compelling right the moment we find it, and when the ideal time to do so comes along.