The Trader's Credo
Let your profits run
Cut your losses
This is completely against human nature. Generally if we have a profit we are keen to close the position and bank our winnings and if we have a loss we are inclined to let the position ride just a little longer to try and get rid of the loss. These natural instincts are completely opposed to the correct way to trade. The trader must set a stop loss (see below) when he opens a position and cut the position ruthlessly when the stop loss is triggered. It can be shown that with a tight stop loss and the correct tactics it is posssible to make a profit while only being right 50% of the time!
Setting a stop loss means that when you enter a trade you set a certain level of loss on the trade at which you will closedown the trade. Stop losses are necessary to protect oneself against unexpected heavy losses. They are also an important aspect of discipline and control when trading. On some internet-based trading systems you can set your stop loss and it will be executed automatically by the system. If you are dealing through a broker you will have to leave your stop loss order with him.
Example of a stop loss: I buy 100 shares in ACME company at 60c per share and I set a stop loss at 45c. That means that if the ACME shares drop in value to 45c each I will sell my 100 shares to curtail further loss.
A good way to capture profit is a trailing stop-loss order. The stop loss is set at a fixed amount or a percentage level below the purchase price of the shares. The stop loss price is adjusted as the share price moves up and is only triggered if the share's price retraces by a fixed amount or a set percentage from the new high. Some internet based trading systems allow you to put in a trailing stop loss on your position, otherwise you have to make the adjustments manually or with your broker.
Example of a trailing stop loss: I buy 100 shares is Shady Sid's Investment Company at 40c each. I set my initial stop loss at 35c. The share later moves to 50c and I move my stop loss to 45c. When the share retraces I am taken out of my position by the stop loss at 45c. Nevertheless I have captured a profit of 5c per share.
Stop loss orders don’t guarantee against losses. When disaster strikes a stock, it may fall so fast the best you can hope for is to come out close to you price. This amount by which you may miss your stop loss is referred to a slipage.
