In the past month, I have received the same blueprint email from about 10-20 readers of my blog. The email basically says: Dear Joe, I bought XYZ stock a while ago and I am down big. What should I do?
I don’t respond to these emails because I can neither give financial advice over email nor do I know ANYTHING about the person emailing me (such as age, financial objectives, risk tolerance, etc.). The only thing I can say is you MUST HAVE some form of loss cutting as part of your strategy. I realize we are in a strong market but that doesn’t mean EVERYTHING is going up. You would be surprised at the horror stories I’ve heard from people recently. For example, one potential client I spoke to last week had a $500,000 account three months ago, but it’s now down to $300,000 because he’s been shorting Nasdaq futures for the past three months. I honestly feel bad but you literally can’t help people who have no loss cutting policy.
I’m a big fan of studying success and when you read about some of the best traders who ever lived, the most common number one rule is: Always Cut Your Losses! Just like the top three rules in Real Estate are Location, Location, Location, one trader says his top three trading rules are Cut Your Losses, Cut Your Losses, Cut Your Losses. When the next correction comes, the traders who remember to stay defensive and stick to this discipline will survive the best.
Where to cut your loss is an entirely different question. A basic rule is your loss should be a function of your expected gain. For example, if you are looking to make +20% on a stock, your loss should be set around -7%. The loss can’t be set at -20% because the best traders in the business are only right 50% of the time and you will never make progress keeping your gains and losses at a 1:1 ratio. Shoot for a 3:1 ratio so you only have to be right on 1 out of 3 trades and still make money. Good luck trading!
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