Cutting Losses

Following my article on "Stops and Whipsaws" last weekend, I received an interesting email from a subscriber. The reader outlined a situation where 100 shares of a stock are purchased at $10 a share and a $10 commission paid. The stock would cost $1,000 plus the $10 commission.

He then correctly pointed out that with a 3% stop, the position would be sold for $970 plus another $10 commission for an overall loss of 5%. I am not sure of the conclusion the reader drew other than that there would be a loss and that would not be a good thing. Unfortunately, all trades do not result in profit and any experienced trader will tell you that some losses are part of the business. In a sense, it is little different from a retail store that makes a profit on many of the items it sells, but sometimes the market isn't too good for a particular product so the retailer discounts that product, makes it a loss leader, takes the loss and moves on to the next hopefully profitable product.

I responded to the subscriber by saying that it is a good thing to cut a loss. Yes, on the 100 share deal at $10 a share with a $10 commission getting in and getting out with a 3% stop loss the trader would lose 5%, but isn't that better than waiting until the stock drops 10% or 20% or 50%. What is the alternative? Sit and watch the stock drop? To what level? In the crash that began in 2000, the Q's (QQQQ) dropped from over $110 to just under $21. Even today, 7 years later, they have only climbed back to around $45. Many investors, including those who were invested in mutual funds, lost 40% or more of their portfolios because they had no exit. Wouldn't those folks been thrilled to have taken a 5% loss?

The point is that cutting losses is both necessary and critical. The old adage is that the first loss is the best loss. If the stock breaks down through support, get out. If it reverses back up, no law prevents you from reentering the position. Better to be out and watch it continue to fall than to stay in the position and get ulcers watching it continue to take your money. I should also note that the example we used dealt with only 100 shares.
Suppose the investor instead had purchased 1000 shares instead and paid $10,000 for the stock and a $10 commission getting in and another $10 getting out when the stock dropped 3%. Now, there would be a $300 loss on the stock and $20 total commissions. The loss there would only be 3.2%. Would it be better to lose the 3.2% and exit or would you prefer to hold even if the stock dropped to, say $6 a share? Only the individual can make those determinations in their own account and depending upon their own business plan.
In most circumstances (though not necessarily all), I would opt for the early exit knowing I could get back in on a reversal. A review of the Trend Trader Table, for example, will reveal 3 separate and successful trades on PPL Corporation (PPL) where I exited on downturns, took a profit, and then reentered when the stock turned back up.
I urge you to develop your own exit strategy. If you are a buy and hold investor, answer the question "Hold until when?" for yourself. In any event, make the decision on what will cause you to exit before you ever enter a position and, unless some important circumstance changes, stick with the decision.
Good Trading!