Learn To Cut Your Winners Short (by Ryan Mallory)

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One of the problems that I find with trading today, is that there are a lot of popular cliches that people hold on tight to, considering them to be untouchable in practice and theory, and the act of challenging these popular beliefs will label one as a trading outcast, reject, or even dangerous. Just like Maverick in Top Gun:

So what are these cliches that I often find irritable and not nearly as applicable as most traders believe they are?

  • Let your winners run, cut you losers short.
  • Bulls make money, bears make money, pigs get slaughtered.
  • Buy Low – Sell high
  • I'm buying for the long-term
  • I'm going to nibble stock "XYZ"
  • Sell in May and Go Away (okay – so maybe there's been some truth to this one the past couple of years)

And so many more!

Now there are some that I fully subscribe to, because they are contrarian in nature and people may say they embrace the cliche but not really. For instance, "Buy the Rumor, Sell the News". Most people will swear by this belief, and it is a legit one for sure, but who actually practices it? If you know that some biotech company is about to get FDA approval on the drug and it rises 40% into the announcement, it's only human nature to be curious to see what happens after the announcement. And when it is a favorable decision, every one expects the stock to go through the roof, only to realize instead a massive sell-off ensued.

But for the purposes of this article, I want to focus on one popular cliche that seems to be universally accepted on all accounts, and I think for the most part, the way that it is interpreted is wrong at best and devastating to a portfolio at worst.

And that is…

"Let Your Winners Run and Cut Your Losers Short"

Fifty percent of this expression I agree with because it goes without say, that the fewer and smaller number of losses that you incur, the better.

But the first half of this statement I have huge issues with. Similar to some of the comments I made in yesterday's post (Developing Your Moneyball Trading Goals), this expression is more responsible for trading losses than probably any other statement I can think of.

The Problem with this cliche, is that it takes no external variables into consideration. It doesn't take the individual trader into account. Instead it is a broad-sweeping statement that people believe in, because they think that they should, because everybody says you should, and they mold their trading strategy around such a notion.

stock market cliches

But that is total horse manure!

You see, the mentatility that most take, is they'll be up say 10% on a trade, and they'll raise their stop-loss, and everything looks just fine on the surface, but the problem, is the intentions and what is occuring underneat the surface. The trader thinks can go up another 50% and out of fear they place their stop-loss in such a manner so that that they make sure they don't miss out on it. When this happens, the stop-loss is tightened in such a way that they don't get stopped out easily, but when you do that, you increase risk exponentially, and you decision is based on greed to make more in the trade than what you currently have, because the  person is associating their identity with the stock, and fear as well that they will miss out on more gains. 

Instead of increasing the stop-loss to tighten it as much as one can, the traders losens it up and still gets stopped out, because the market doesn't care nor know what those intentions of yours are and indiscriminately takes you out at the wider stop-loss anyways.

What all this suggests is that letting winners run is a faulty mindset and all it pretty much does is allow what the expression sets out not to do – to "let winners turn into losers."

I'm not saying that I know the ideal exit or where you should get out every time, but I do believe in getting out on strength, and not waiting for the market to prove you wrong before getting out and not holding out hope that the trade is going to turn into some wild, magic carpet ride.

And the reason why I write this, is not because I'm any better trader than the people reading this, but because I've struggled myself with this very issue in the past. I can't tell you how many times in my trading past, when I subscribed to this belief, that I allowed winners to turn into losers for the reasons stated above. Now while I might have been successful in my trading overall, I have to ask myself, how much more could have been had, by simply capturing the gains earlier than I did. I didn't respect like I should have, the gains that I'd have on a position, whether they were big or small. Instead, I would just raise my stop-loss up, just enough that I don't get taken out of the position because I'd, without realizing it, feared missing out on the big move due to being stopped out prematurely.

In the end you have to decide how you are going to manage your trades. And I fully expect a number of people to disagree with me on thsi subject, but feel free to leave your thoughts and opinions in the comments section below and we can discuss it.

But if you're to ask me, I belive that the popular cliche, should instead read "Keep your winners as winners, and cut your losers short."

You do that, and you'll be just fine.

Check Out Ryan's Trader Network at SharePlanner.com