Shares Trading for larger profits
What is shares trading and what is a stop loss price and why should we have one? OK let’s start at the beginning.
Shares trading is buying and selling shares, normally in a time period of weeks through to months to make a profit. To make larger profits when trading shares it is vitally important to have a stop loss for every trade.
A stop loss price is a pre-determined price that we use as the trigger to sell out of a losing trade. In other words, if the share price falls instead of rising then we sell and we sell at a pre-determined price to ensure that we don’t lose too much money.
Sensible? Yes. Logical? Yes. Straight forward? Yes.
Yet in a recent survey of frequent share traders in Australia, 21% didn’t really know what a stop loss was or how to use one. And of the 79% that did know what a stop loss was, 30% never or hardly ever used one. At Just Shares we believe that if you want to make money repeatedly and sustainably from shares trading then using a stop loss is absolutely essential – for every single trade. In fact we believe that your first responsibility when trading shares is protecting your money. And the main way that you protect your money is with a stop loss. (The other way is through Position Sizing which is the subject of a separate article).
Just a word on why we need to have a stop loss price. Quite simply because not all trades succeed – some fail. Even the best trading techniques on the planet struggle to deliver a success rate of much more than 70%. Therefore even using some of the best trading techniques that exist we will still end up with two or three losing trades out of every ten. For these losing trades we must keep our losses really really small.
Another way of thinking about shares trading, or investing for that matter, is that any trade, or investment, can only have one of five possible outcomes:
- A large profit.
- A small profit.
- Unchanged or breakeven.
- A small loss.
- A large loss.
That’s it. Five possible outcomes, no more, no less. Every single trade will result in one of these five outcomes.
Now if we could eliminate one of these five outcomes, which one would we choose? That’s right – the large loss.
If we eliminate the large loss we are only left with the other four possible outcomes. If our small losses, breakeven trades and small profits even out over a period of time we will only be left with the rather pleasing occasional large profit. If we are using trading techniques with a success rate of more than 50% then we will be generating a regular profit stream from the small profits because we will have more of these than small losses. And we still have the pleasure of the occasional large profit.
By now there should be no doubt in your mind about the wisdom of eliminating large losses when trading shares. So what do we use to eliminate the large losses? The Stop Loss is what eliminates the large losses. So the question then becomes how do you set your stop loss price?
One of the most commonly published ways of setting a stop loss price is based upon calculating 2% of Trading Capital. Here the Stop Loss price is set at the level where you would lose 2% of your total trading capital.
A Stop Loss Rule, we call this the Golden Rule of share trading at Just Shares, typically has three parts to it:
- Always, and I do mean always have a Stop Loss in place for every single trade that you do. No exceptions.
- The Stop Loss price is set at the level where your loss will be 2% of total trading capital.
- When your Stop Loss price is hit then you must sell. No ifs, no buts, no maybes. No waiting one more day/week/month/year until your trade turns into a “long term investment”.
For those new to share trading, and maybe some not so new, the most difficult part of this rule is part 3, selling when your stop loss price is hit. It’s the most difficult part of the rule because it brings into play your emotions. Emotions of fear of loss and the hope of better things to come if you tough it out. And of course our ego pops up and it just hates us admitting that we were wrong about anything! Despite this huge emotional drag not to sell – sell we must. When your stop loss price is hit you sell. This is about protecting your hard earned cash. Want some proof?
If I am trading with $10,000 and if I have a losing trade of say 20%, my $10,000 will be reduced to $8,000. That is the original $10,000 less 20% ($2,000).
Now in my next trade I am starting with $8,000. If I make a 20% profit my $8,000 will increase to $9,600. That is my original $8,000 plus 20% ($1,600).
Let’s stop right here. I have done two trades, one lost 20% and one gained 20% but I am down $400. This hardly seems fair. But then the share market doesn’t care about fairness. Welcome to the reality of share trading!
Want some more proof? As the table below shows, the larger a loss gets the worse the situation gets:
| Size of loss | Gain needed to recover |
| 10% | 11.1% |
| 20% | 25.0% |
| 30% | 42.9% |
| 40% | 66.7% |
| 50% | 100% |
| 60% | 150% |
| 75% | 300% |
| 100% | ruin |
So hopefully we can agree on the importance of keeping any losing trade really really small. How small? No more than 2% of our total trading capital.
For example, if my trading capital is $10,000 then 2% of my trading capital is $200. So if the price of the share that I am trading should fall to the level at which I will lose $200 (2% of my trading capital) then I sell. This is simple and straight forward but it protects your hard earned cash.
One draw back of this very simple method of protecting your money is that the share price that the dollar figure, in this case $200, relates to doesn’t necessarily have any connection to what is happening on the share price chart. In other words your trading technique my be saying to stay in the trade but your 2% stop loss has been hit and is screaming “sell”.
Most shares trading techniques are designed to give you an exit signal – the technique will tell you when to sell. Normally the trading technique will give you an exit signal that is connected to the underlying price movement of the price chart of the share that you are trading. For example a simple moving average cross over will tell you when to sell based upon the averages crossing over in the wrong direction.
So the trading technique manages your exit but if you enter a trade and it goes against you straight away – how can you marry your trading technique’s exit, particularly if it has a lag built into it, with your desire not to lose more than 2% of your trading capital? This is what Position Sizing is about – we look at Position Sizing in a separate article.
The key principle here is always have in place a price that if the share price falls to this price, you sell and cut your losses. Protecting your hard earned cash is your most important task when trading shares. A good starting point is to cut off your losses at 2% of your total trading capital, and then combine this with your trading technique through Position Sizing. Shares trading to make money is more successful with a stop loss.