Preservation of Capital
One of the secrets of successful traders is what should be at the back of all traders minds whenever they are making any trades, and that is preservation of capital.
The money you have set aside to trade with (your ‘working capital’) is what allows you to seize opportunities and make profits. Whilst it’s true that if you make a losing trade you haven’t actually lost any of your capital until you sell your losing position, however this is not a tenable trading strategy.
Yes, the losing stock could always come back up again, and if you wait until it does, then you can get out without a loss (or even at a profit). Normally in situations like this most traders sell as soon as the stock returns to the level they bought in at, happy to be out of a sticky situation.
This is of course assuming the stock does eventually recover, rather than continue down until it finally evaporates your capital altogether.
The problem is that while they are holding on to their losing position waiting for the stock to recover, their working capital is effectively dead money. It could be locked up for weeks, months or even years.
Anyone who’s ever traded or invested their money in stocks has experienced this at some point. In fact, with the markets as they are, most trader/investors are holding on to dead money right now.
So how do we preserve our capital?
The obvious one which we all know and hear about is the stop loss. I’ve covered why, how and where to set the stop loss in the article Stock Market for Beginners – The Stop Loss, so I won’t go into it here, but the problem with the stop loss is that it doesn’t really protect your capital.
Yes, it protects the vast majority of your capital, but if you’re unlucky enough to have made several bad trades in a row, then even several stop losses in a row will consume a lot your of capital.
In order to really preserve our capital we need to do more than place a stop loss. We need to move that stop loss to the price at which we bought the stock, let’s call it a ‘breakeven stop’, and we need to do it as soon as possible.
In this way, if the stock does turn against us and we get ‘stopped out’ then with a breakeven stop in place all we would lose would be the cost of the trade, and perhaps a little pride.
We could call this a ‘cost-of-trade loss’. In the bigger picture this will be the cost of a lesson in something, somewhere. A small price to pay if the lesson is learned.
Be careful not to move the stop loss up to a breakeven stop too early. You should give it a few days at least and allow it to make a new significant support level going up.
Also, if we have just taken advantage of a prior price pull back and bought in after a reasonably sharp turnaround (not capitulation), then there is a danger we need to be wary of. Fundamental analysts would call it the ‘double bottom’.
We must give it enough time to do that if it is going to.
We obviously do not want to bring up our stop loss until this has happened. We don’t want lots of small cost-of-trade losses, they can add up. On the other hand it may not happen. Possibly it may happen a third time (a triple bottom). Our next move will need to take all this into account, and that means giving the stock time to do what it needs to do.
Getting a feel for the way stocks move like this will take a little time and experience (this is what you will gain at the cost of a losing trade). Trust me, in the end your experience will be far more valuable to you. These secrets from Ten Steps to profitable Trading looks at this in more detail.
When it comes to moving our stop loss up to a breakeven stop at the right time, there is a couple of things we must look for.
If the stock heads upwards and seems to be getting well clear of your buy in point, has created a support level and at least three trading days have passed since you bought in, then you can consider moving your stop loss up to a breakeven stop.
Leaving it for five days would on occasion be better, especially if the stock is not advancing confidently or is not making new minor support levels going up.
If the stock does come down and bounces off the support level (just above our stop loss) we can only hope that there is enough leeway for our stop loss to not get triggered.
Assuming it doesn’t get triggered, and the stock drifts back up then we are back to breathing regularly again and hoping that the stock will carry on going up.
Move your stop loss to its new breakeven stop position (i.e. to the price point where you bought in) when you are confident there is little threat that the stock will turn down again in the near future, and if it did, would probably take at least two or three days downward drift to reach you.
Better still allow it to create a new significant resistance level, a new significant support level, then subsequently break through that new resistance level to start another run away from your buy in point.
There are many strategies you can use when you are trading and the best of them have been reviewed for you at Stock Trading Strategies.
This tactic is all part of the Ten Steps to Profitable Trading which you can learn more about at Best Trading Strategy.