When should you cut losing trades?
One of the biggest mistakes a trader / investor can make is not cutting their losses fast enough. Why is this such a big deal? Well there are two reasons – 1) Margin Calls and 2) Losing trades which will lead to a smaller portfolio.
So, first of all, what is a margin call? A margin call defined (by Fidelity) as a demand from your brokerage firm to increase the amount of equity in your account. You can do this by depositing cash or marginable securities to your account or by liquidating existing positions to generate cash.
That basically means that you’ve entered into a losing trade and in order to keep your account active and alive you’ll have to PUT more into it or else it’ll be wiped out and your net liq will be $0 – in other words… you lose.
A margin call is one of the worst things that can happen to you as a trader or investor.
Now, let’s move onto the next reason why – losing trades. Another undesirable event that traders / investors have to encounter are losing trades. Now everyone takes a loss every now and then, it’s inevitable unless you know exactly what you’re doing and your timing is impeccable. HOWEVER, the best traders and investors KNOW when to close a losing trade. If a trader or investor enters into a trade and the price of that trade goes in the opposite direction of what they intended, then that trade might be negative. Most traders and investors CLOSE their trades if the amount is anywhere from 1-5% of their account size – leading them to a SMALL loss. Keep in mind that a SMALL loss is better than thinking the market will turn around (which can lead to a larger loss).
So for example, if you have a $10,000 account and buy a CALL option anticipating that the price will go up and the price does down, then it would be wise to CLOSE the trade at -$200 or below. Personally, at AGC, I like to close my trades as close to break even or as small as possible or at around 2%.
Ideally, a trader / investor should have: 1) big winning trades, 2) small winning trades, 2) small losses, or 3) break even trades. All traders should do their BEST to stay away from big losses. Common sense right?
Well why do traders and investors have big losses anyway? What leads to it? From my experience I’ve realized that some traders predict that the market will turn around so they’ll allow themselves to stay in a losing trade for long period of time hoping that it will go back up or down – and sometimes it does – but most of the time it doesn’t. Another reason why is because the trader / investor doesn’t know what they’re doing. They aren’t using indicators or support / resistance levels. The last reason why is due to negligence. Their mind isn’t on the chart.
Avoiding and Managing Margin Calls – Fidelity.