The Importance of Respecting Your Stop

  • SumoMe

Sometimes as a trader or investor you come across an idea that seems perfectly reasonable.  Based on sound theory, perhaps some real world experience to back it up, a decent probability of making money and of course a stop-loss – or “uncle” – point to keep any potential risk at a reasonable level.

Like I said, it all sounds perfectly reasonable.

And then it all goes to hell.

Welcome to the exciting world of trading and investing.  If you have been in the markets for any length of time you probably know what I am talking about (“Hi, my name is Jay”).  And sometimes, just to compound the “palm of hand to forehead effect”, it all goes to heck beginning almost immediately after the moment you make your move.  Guess what, it happens.  And it sucks.  And it hurts.  And it embarrassing, infuriating, it shakes your confidence and it costs you money.

And – repeating now – it happens.  So the only question that really needs to be asked and answered is “did you limit your loss to an acceptable amount?”

(See also Jay’s Trading Maxim’s (Part 1))

But here is what you really need to know:

*Too often people let this scenario shake their confidence on the next trade

*Too often people dwell on the “how could I be so stupid” effect

*Too often people change what they are doing based on one bad trade – which ultimately costs them more money down the line

*And way, way too often people do not respect their stop-loss point – typically because they don’t want to be proved to be so horrifically wrong (“maybe it will turn around if I just give it a little longer”).  Which is exactly how one bad trade can derail even the most diligent trader or investor.

So here is what you really need to remember:

*First adopt a sound investment plan/method in which you have confidence

*Trust your analysis but also recognize and accept that bad things can happen at any time

*Follow your investment plan

*Always (always, always) respect your stop-loss points

More on this last point.  On 6/1 I wrote a piece detailing a step-by-step process for finding what I call “Credit Spreads in Summer”.  It is a very logical process based on sound theory (the market long-term tends to struggle during the summer months, selling call credit spreads on overbought stocks during this time has a high potential for success, the trade I highlighted had about a 1-to-1 reward-to-risk ratio- which is good for a credit spread, etc.)

The trade I highlighted involved selling a bearish call credit spread on ticker LULU.  It looked pretty good to me.  But here comes the key part of this article:

*The key premise to making this trade was that the trader must be willing and able – financially and emotionally – to risk roughly $800.  If losing $800 – whatever the circumstance, however that loss came about – was something that might cause a crisis of confidence or affect your trading going forward then the trade should not have been taken.

And then it all went to hell.

On 5/27 LULU closed at $64.69 a share.  Our stop-loss point was above the recent high of $69.73.  It took just 7 short trading days for LULU to zoom straight past the stop-loss point and close at $71.48.1Figure 1 – LULU credit spread goes immediately wrong (Courtesy www.OptionsAnalysis.com)

Getting stopped out when LULU broke about $69.73 would have resulted in a loss of roughly -$800.  Which is exactly what one had to be willing and able to risk at the time the trade was entered.

So (at least in theory) in the whole big spectrum of things, this trade was just “a cost of doing business” and should already be forgotten.

But that is not the way most people’s mind works.  A more typical response might be:

“I should find a better way to identify bearish credit spreads”

“Maybe I should trade bearish credit spreads at all”

“I cannot believe I got stopped out in just 7 days”

“I am so embarrassed that I posted an article that ended up being such a bad trade”

“Maybe next time I will use a really tight stop so I don’t lose as much money”

And so on and so forth.

The Whole Point

The thoughts in quotes above are what leads people down the wrong path.  The quotes below represent the way successful traders think:

“The decision to risk $800 was made”

“Action was taken”

“$800 was lost”

“A cost of doing business was incurred”

“Move on to the next trade”

One Final Point

Note that if a trader in this trade had not respected his or her stop-loss point (and exited with a loss of $800), by the end of the day on 6/8 he or she would have been sitting with an open loss of -$1,314.

Is it possible that this trade “left to run” might still end up showing a profit?  Absolutely.  Or it could into an even larger loss.

The successful trader has already cut bait and moved on.

Here ends the (albeit, painful) lesson.

Jay Kaeppel

 

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