The biggest thing a trader has to do in order to be successful is protect himself and stay in the game when things get rough. As any honest trader can tell you, bad patches can be brutal and seem like they can last forever. During these periods, traders can follow a set of rules in order to survive. However, this one is my favorite and the hardest to adhere to. Cut any loss at 8%, no matter what.
Fighting Human Nature
I learned this rule by reading Investor’s Business Daily (IBD) and is a key rule from its famous founder William J. Oneill. The logic of the rule is so simple that it almost doesn’t need to be explained, but believe me when I say it is extremely difficult to follow. Nobody wants to sell at a loss and admit that they made a mistake. That goes against human nature as studied by numerous behavioral finance tests. Ego is one of the biggest enemies of the successful trader and this is a great test of that.
Another reason people may find it hard to follow this rule is that many stocks will immediately whipsaw you and turn higher after you sell it. This is a huge slap in the face that will cause many investors to permanently abandon this rule. Nothing hurts more than to sell your stock at a loss, only to watch it bounce back and soar to new highs. But I assure you it is less painful than holding onto the next Worldcom all the way down. Many traders even average down into these stocks, which is akin to throwing good money after bad.
Cutting losses is strangely cleansing mentally as well. It allows you to take an objective look at what is happening rather than being emotionally involved in a losing position. If you made a mistake and like the stock again, nothing is preventing you from buying it right back. It will prevent catastrophic losses. If a stock drops 50%, it would have to double just for you to get back to even. Try this rule out for a while, and you might just improve your results.
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