The Secret To Market Success

Do you know the secret to having success in the stock market? If you said that the secret is knowing which stocks will be the winning performers, you are wrong. The real secret is being able to recognize a losing trade and cut your losses early.

Recently I read an article from about using stop loss orders to cut your losses and I thought I would expand upon the importance of the stop-loss order.

The Real Secret
It would be nice if we were all able to select a winning trade each and every time. Unfortunately nobody is right all of the time, not even the high-paid professional traders. Therefore the real secret to market success is knowing how to minimize your losses and preserve capital for the next trade.

Bernard Baruch once said:

Even being right three or four times out of 10 should yield a person a fortune if they have the sense to cut losses quickly.

Think about that for a minute. You don’t need to be right on each and every trade to make money in the stock market if you understand the importance of minimizing your losing trades.

Eliminate The Emotion
It is human nature to resist admitting a mistake and many stock traders become emotionally attached to a particular stock. Be honest with yourself, how many times have you purchased a stock that has decreased in price and you keep telling yourself that it will come back? Trust me, I know because I have done the same thing.

When I first began to learn about technical analysis and started to become a little more active with my trading, I learned the concept of using stop-loss orders to minimize my losses. Initially I would use “mental” stop-loss orders, meaning I knew what price that I should sell the stock if it were to drop but I didn’t set a firm order until that happened.

Unfortunately I ran into a few trades where the price did drop and as it hit my limit where I should have been selling with my mental stop-loss order, I tried to rationalize that the stock would come back and I kept holding the stock. As I am sure you can guess, the stock price continued to drop and I ended up selling the position later for a larger loss.

When you purchase a stock, you will be doing yourself a huge favor by setting your stop-loss order immediately after the purchase. The reason that you want to do this is that you eliminate the emotional aspects of selling a stock that is losing money. Do not let your pride stand in the way of admitting a mistake, act quickly and cut your losses while they are still small.

Setting Your Limit
What is a good number to use as your stop-loss trigger? As with most things in life, different people will use different values but in reading the books of William O’Neil, founder of Investor’s Business Daily, I have learned to set my limit at a 8% loss.

When a stock falls 8% below my purchase price, I sell the stock and preserve my capital for the next trade. Sure, there have been times where I have sold a stock only to see it rise right back up a day or two later. However, more times than not the stock continues to drop and not selling would only put me in a deeper hole.

Consider the following, if you buy a stock at $100 per share and it drops 20% to $80 per share, are you aware that you now need a 25% gain just to get back to the $100 purchase price? How about a stock that drops 50%? In that case you now need a gain of 100% just to get even. That is not a recipe for long-term success in trading stocks.

If you are buying stocks at the proper purchase points, you can be pretty certain that there is something wrong with the stock if it is dropping to your 8% stop-loss order so it is best to cut your losses and live to trade another day.

Use This Secret For Success
By now you can likely see the importance of cutting losses early before they have a chance to become large losses. Learning how to use the stop-loss order effectively will allow you to eliminate the emotion from your stock trades, which is often one of the biggest hurdles to becoming a successful stock trader.

Don’t allow your stubborness of admitting a mistake cost you more money in the long run. Remember what Bernard Baruch said regarding how often you need to be right on your stock trades if you learn to cut your losses early, three or four times out of ten doesn’t seem quite so daunting now does it?

You may also like...

7 Responses

  1. Derrich says:

    Couldn’t have said it any better myself. Great post! And thanks for the link love.

  2. George says:

    Using stop losses is not the real answer to stock market success. The real secret is to only invest with a significant margin of safety in stocks where you are comfortable estimating their “true” intrinsic value.

    • Derrich says:

      Rightly so. However, I think this post assumes that you’ve already gotten to that point in your investing decision…although I can’t speak for Derek.

    • mnc says:

      As Derrich mentioned, I did assume that this is generally true that you are selecting stocks that meet your appropriate criteria.

      However, even when you have picked the right stock for the right reasons that doesn’t always mean the price is going to do what you expect it to do and stop-losses protect you.

      One common complaint with a stop-loss is that when triggered it becomes a market order and opens the door to losing even more money on a sharp drop. However, I believe that is the extreme and while possible it is not very common.

  3. Gary Brown says:

    The stop/Loss method of investing can only be used for individual stocks, is that correct? I work strictly in the auto and home insurance market but find the information extremely interesting.

  4. Stop losses are good in the right system, in others they are detrimental to it’s performance and other exit strategies work better. The trick is to find the balance in getting a system that performs well, that does not have too harsh draw-downs and, most importantly suits you – both psychologically and in the amount of time you have to dedicate to it. However having said this, if you do not have the dedication to stick to your trading system, then it will never deliver the results….
    The point about only having a low hit rate and making money is also very valid and you tend to find that this is closer to the results that the very best traders get. They want their winners to be home runs and their losers will never take more than a few percent of their total equity before they are sold. As an example to make this clearer, imagine that you have a 1 in 4 chance of finding a winner (25%) but on average your winners make 100% and your losers lose 10% each. If you start with $4000 put $1000 into each of your trades, this means that each loser will mean you are left with only $900. Since you had three of those, you now only have $2700 of your $3000 left. However your other $1000 trade is now worth $2000. This means that your original $4000 is now worth $2700+$2000=$4700….kerching!
    I wrote a fuller explanation of what makes a good trading system here I hope it’s useful.

Leave a Reply

Your email address will not be published. Required fields are marked *