The Importance of Cutting Loss

Cutting loss is an essential risk management tool for our long term health as traders. If you lose your capital in the markets, you are as helpless as a soldier without any fire power (bullets) in the middle of a war.

By not taking the loss when it is small, we are allowing the market to dictate our emotions and more often than not, we’ll lose control of the situation when the losses against us are too much to bear. And at that moment after you decide to sell and take your huge loss, you end up selling your stock right at the bottom as the stock price rebound.

You know that you are losing control of the situation when you find yourself hoping that the market would reverse direction and move higher back to your original purchase price. This is what they call “hopium” for traders. You know you are on “hopium” when your losses are too huge for you to cut. At that moment, a trader can only hope that he could turn back the clock and had taken his losses when it is still small. Never lose control of the situation.

Buying insurance

Many a times, after we cut our losses, the stock price would tend to bounce back after the market makers shake out the sellers of the stock. Take this as your insurance fees. If you lose $200 and the price comes back up, you can always re-purchase your stock at a higher price. This $200 would serve as your insurance fees. So, what if you do not like to place stop loss orders and dislike “paying” for this type of insurance?

Scenario: Trader A placed his trade with a stop loss of $200 while Trader B chose to trade without a stop loss. The stock was then hit by a wave of selling and the price moved lower through Trader A’s pre-designated stop loss price and Trader A was promptly stopped out for a loss of $200. What about Trader B? He chose not to pay for insurance and could only watch as his stock price moved lower as the stock broke through a series of support level and he is now $2000 in the red instead of the small loss of $200 which Trader A took for this trade. Trader A in the meantime after getting stopped out even turned bearish and shorted the stock on the way down while Trader B could only lick his wound and watch as his capital is stuck in the stock. In extreme cases, it might take the stock years to come back up to its original high.

Of course, one might argue that the stock market has the tendency to go up instead of down over time. However I would like to point out that it is the stock market index that is going up over time. Weak companies in the index would be replaced with companies which are healthy and robust. One extreme case was Enron in 2001 when its share price plunged from $80 in January 2001 to less than $1 in late December 2001. Enron was then part of the S&P 500 index and was eventually declared bankrupt. It was duly replaced by another healthier company. And yes, you guessed it, the S&P 500 then climber higher 3 years later.