Know when to cut your losses

Having a good understanding of the price trend of a security is very important, as it assists us in deciding when to buy and sell securities. 

It helps us identify potential entry and exit points within the price trend of the security we are trading. 

This is obviously very helpful, but traders need to protect themselves from taking losses when they get it wrong. 

This is where risk management comes in.

There are many complex rules when it comes to risk management. 

For now, let’s focus on the basics to lay a foundation on which we can build. 

1. Trade with the trend

In my previous column in the 7 February issue, I focused on how to identify the trend – and why you must never trade against it. 

To recap: The first step is to identify the primary, secondary and tertiary trend (tip: use around three to five years of daily price data to determine the primary trend). 

Your goal is to find the points at which either the tertiary trend ends, and the secondary trend continues (if you are slightly riskier), or the points at which the secondary trend ends, and primary trend continues (if you are less risky). 

These serve as entry points for trades that trade in the same direction as the chosen trend (in this case, either the secondary or primary trend). 

Usually these points are at intersections and breaks, as shown at points 1 to 4 in the graph below.

2. Predetermine the risk

You must decide how much money you are willing to lose if you get the trade wrong, before you take the trade. 

You then set a stop-loss for the trade to ensure that you will only lose a predetermined amount. 

A stop-loss is a price or level at which you will admit that you are wrong and accept the loss by closing your position while the loss is still within your predetermined parameters. 

The best place to set a stop-loss is at a price level where you can comfortably say that you are certain the trend has changed. 

Based on Dow Theory, that is usually two previous lows ago, as indicated in the graph.

Based on how far that stop-loss is from your entry price, you can calculate how many shares to buy to only lose your predetermined amount of money. 

As a rule of thumb, this predetermined amount should be a percentage of your portfolio not exceeding 2% (the smaller the better). 

The box below serves as an example of this calculation.

3. Never add to a losing trade

Often traders put a lot of effort into identifying trading opportunities and find it very difficult to admit that they are wrong. 

This leads them to making a very common mistake: Instead of stopping out of a trade (taking the predetermined loss while it is still small), they add more to it (buy more shares). 

This increases the risk exposure and often ends in tears, as the trader is likely to keep adding to the trade each time they believe that “this time it’s finally turning in my favour”. 

This is rooted in our general belief that ‘we need to work hard for money’ and ‘being wrong is wrong’. 

Neither of those are true in the markets. Rather consider stopping out of a trade as the cost of doing business. 

This is a test of your self-discipline, and probably the first step to reprogramming the way your brain works so that you can survive in financial markets. 

Adding to a trade that is losing money might save you on the odd occasion, but eventually it can destroy your entire trading account (and career). 

Written on a sticky note, stuck to the screen of one of the best traders I have ever met, is the very simple rule: “Losers average losers”.

4. Never trade when the risk-reward ratio is smaller than 1:2

Taking trade entries at key ‘trend-changing’ points usually gives you the ability to estimate where the price might go in future by measuring the ‘waves’ that the price movements make, or by measuring the ‘distance’ between our entry price and a potential resistance level. 

You should always try to enter trades only when the distance between the anticipated ‘target price’ and the entry price is at least double the difference between the entry price and the stop-loss price. 

In other words, for every R1 you risk losing if you get the trade wrong, you expect to make a least R2 if you get it right. 

So even if you only get just over 50% of the trades right, you will still be profitable over the long run. 

It’s a bit of a blend between risk management and psychology, because understanding the concept of risk management rules is one thing, but sticking to these rules is often the real challenge. 

This is where self-control becomes the difference between successful traders and everyone else. 

Petri Redelinghuys is a trader and the founder of Herenya Capital Advisors.

This article originally appeared in the 21 February edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.