How Stop Losses Keep You In For The Big Win

This is the point where you admit you were wrong. No one can pick winning stocks 100% of the time. Accept this fact. You can only play the odds.

Let’s say we buy a stock at $20 with the plan that it will go up to $24. Now we have to decide what to do if the stock does not go up, but suddenly starts to fall. Let’s decide that if the stock moves below $19, we will accept that we were wrong about the direction of the stock, sell the position immediately, and take a small loss. By taking small losses, we preserve our trading capital, which allows us to trade again tomorrow.

Before we even get into a position, we have to measure our risk-reward ratio. In the above example, if we were correct about our stock pick, we would have made 4 points. If we were wrong in our stock pick, we would take a loss of 1 point. That is a risk-reward of 4:1. Let’s say we were only correct about our stock picks 50% of the time and we make four trades. Two were winners (2 x 4 points) equaling 8 points. Two trades were losers (2 x 1) totaling 2 points. We now have a gain of 6 points by only selecting winning stocks 50% of the time. Assuming we were the worst stock pickers in the world and were only correct 25% of the time, we would still have a gain of 1 point.

It is important to keep your risk-reward ratio 4:1. If you can only find a risk-reward ratio of 2:1, leave it alone, sit on your hands, and do nothing. If the market is behaving in a way that you can only find risk-reward ratios of 2:1, you probably have no idea as to which way the market is going to move. The market spends most of its time moving sideways. I have seen many traders lose most of their capital by making themselves trade when they should have stayed on the sidelines.

I still remember the first time I stared at the screen the entire trading day from 9:30 a.m. until 4:00 p.m. without making a single trade. I was thinking to myself, “I know the market is normally irrational, but today I have absolutely no idea what is going on.” I made some paper trades in my head, and I was glad I had left it that. All the trades I made in my head were losers. Even though I did not make any trades that day, I felt like a winner. It was a great feeling to know when to sit it out. I was right to stay on the sidelines. You have to have the discipline to stay on the sidelines when you do not feel comfortable. Getting into low risk-reward positions because you want to be in the game is wrong. It shows a lack of discipline and the punishment is losing capital.