Last Updated on October 11, 2023
Trading the markets is an exciting activity that can be both rewarding and risky. To ensure it is more of the former than the latter, one of the most important lessons traders must learn is when to start cutting their losses.
In this article, we will discuss the importance of cutting losses to preserve your hard-earned gains. By being aware of when to exit a trade, market participants can avoid making emotional decisions and remain disciplined, which is crucial for consistent success in the markets.
The Art of Cutting Your Losses
Even the most experienced traders face significant market losses. However, the difference between the pros and those new to trading is the ability of the former to keep their losses small and rare.
Learning how to cut losses generally means knowing when to exit a trade. More often than not, there are situations where traders stay too long in a losing position, hoping their luck will turn around in their favor or closing a winning position too early.
Successful traders understand that taking a loss is a part of the trading process and that it is better to lose a little now than to lose a lot later.
Several factors can impact a trader’s decisions, including emotions, different levels of experience, unexpected market events, and so on.
Nevertheless, there are a few established principles every trader should be aware of before entering the market.
For example, a trader opens every position with the intention of making a profit. But they should know that won’t happen every time. Sometimes the smartest thing to do is to accept that your trading decision was bad and close the position before sustaining further blows.
The single most important thing to remember is that the earlier a trader accepts a loss, the more capital they will protect in the long term. Making consistent profits is just as important as protecting their portfolios. Put differently, having a clearly defined trading strategy means positioning yourself for success while also mitigating the risk of significant losses.
Reasons for Not Cutting Your Losses
There are various reasons why traders don’t cut their losses. One of them is being too emotionally attached to a trade. Sometimes, investors may feel like they have invested too much time, effort, and money into a trade, making it difficult for them to accept that they have made a wrong decision and stomach the loss early.
But failing to control emotions in trading can easily cloud one’s judgment and lead to impulsive decisions that can ultimately result in significant losses.
Another common reason why traders don’t cut their losses is the fear of missing out (FOMO). For example, inexperienced traders often hold on to a trade that isn’t profitable, hoping that the market will eventually turn in their favor and they will turn a profit. Just like emotional trading, FOMO can also lead to irrational decisions and damage traders’ portfolios.
Risks of Not Cutting Your Losses
Not limiting your losses early on risks causes a snowball effect, where the losses multiply down the line.
One of the biggest distinctions between experienced and rookie traders is that the former know when to accept a defeat and when to stick with their moves.
Another risk of not cutting losses early on is that sometimes traders may end up investing more money into a losing trade to try and recoup their losses. This can lead to a vicious cycle where the trader keeps investing more money into the trade, hoping to break even, and before they know it, their portfolio is wiped, and their confidence is completely shattered.
How to Cut Your Losses – Know When to Exit a Trade
As mentioned above, cutting losses in trading basically means knowing when to exit a trade (when to stop trading and call it a day). This is one of the fundamental things that every investor must learn in order to avoid major drawdowns.
Professional traders use different methods to help them determine when to exit a trade, but all of them have a clear exit strategy in place to cut losses when needed. That said, traders should define their exit points before entering a trade and stick to them regardless of emotions or external factors. This can help avoid making impulsive decisions based on market noise or emotions.
Furthermore, traders should learn to adjust their exit points based on market conditions. For example, if a trader is bullish on an asset’s long-term prospects, they may choose to adjust their exit points to allow for larger potential gains. Similarly, if market conditions change, they should be prepared to exit the trade earlier than initially planned to limit potential drawdowns.
Knowing when to exit a trade is an essential skill for traders to limit potential losses and improve their overall trading performance. There are several methods traders can use to determine when to exit a trade. By learning to use the techniques we’ve covered below, traders can put themselves in a favorable position to make informed decisions and close their losing positions at the right time.
Stop-Loss Orders
A stop-loss order is a type of order that closes a trade when a specified price level is reached. This is one of the most effective and commonly used tools to limit losses and remove emotions from trading decisions.
For example, a trader could set a stop-loss order at 2% below the entry price for a long trade. This method, known as the 2% rule, prevents traders from putting more than 2% of their account equity at risk on a single trade. For instance, if your account is currently worth $10,000, and you choose a risk management stop loss of 2%, it means you have chosen to risk no more than $200 on a particular trade.
Using Fundamental & Technical Analysis Tools
Technical analysis is a trading discipline that relies on charts and indicators to identify trends and price patterns. Traders can use technical analysis to identify potential areas of support and resistance and use these levels as exit points. For example, if a trader identifies a major resistance level, they could close the position if the price fails to break above it.
Similarly, some traders use fundamental analysis to determine when to exit a trade. The main purpose of fundamental analysis is to assess the value of an asset by examining economic and financial data. However, traders can also use this information to determine when to enter or exit a trade. For example, if a company reports disappointing quarterly earnings, it may be wise for a trader to close their position in that company’s stock to limit potential losses.
Having a Clear Strategy and Sticking to It
No successful trader has done well without a proper trading strategy.
Having a clear strategy means knowing what you want to achieve and developing a plan for how to achieve it. That’s why every decent strategy involves a plan that outlines entry and exit points, the amount of capital the trader is willing to risk, and their profit targets. It also allows traders to make rational decisions and avoid making reckless moves that can result in losses.
However, having a trading strategy is just a part of the equation. The more important thing is discipline and learning to stick to your strategy.
Imposing Proper Risk Management Controls
Cutting losses means assessing and preparing for potential market disruptions. To do this, traders use a set of risk management controls that can help them reduce or eliminate such threats.
Every trade comes with its inherent risk, which is why it is crucial to determine the amount of capital you’re willing to risk before entering. By imposing proper risk management controls, traders can limit their losses and preserve their capital, which is essential for long-term success in trading.
A general rule of thumb is to risk up to 1% to 2% of your account’s value on a single trade and no more than 5% across all positions at any time.
Backtesting
Backtesting refers to testing a trading strategy with paper money using historical data to determine its performance and accuracy. This is a popular method traders use to compare the viability and feasibility of different trading strategies, allowing them to make necessary tweaks to develop and employ the most successful trading plan.
Many traders consider backtesting an essential step in developing a trading strategy as it allows them to identify potential weaknesses and areas of improvement. There are two main components that are analyzed during backtesting, including overall profitability and the risk level taken.
By testing a strategy using historical data, traders can get an idea of how the strategy performs in different market conditions and determine whether it is profitable. The idea is that if a certain trading strategy delivered a poor performance in the past, it is unlikely that it will perform better in the future.
Conclusion
Cutting losses is an essential skill that all traders should learn. It is impossible to avoid losses in trading completely, but there are specific methods and strategies successful market participants use to minimize their amount.
By knowing when to exit a trade, traders can avoid making emotional decisions and remain disciplined, which is crucial for success in the markets. Traders should have a clear strategy and stick to it, impose proper risk management controls, and backtest their strategies to ensure they are well-positioned to ensure long-term profitability.
