Cut Your Losses, Let Your Profits Ride: Explained

Ganesh Adhikari

The elements of good trading are: 1. cutting losses, 2. cutting losses, And 3. cutting losses. If you can follow these three rules, you may have a chance.’ – Ed Seykota

“Cut Your Losses, Let Your Profits Ride” is one of the appealing sayings on Wall Street. The aim is to encourage investors and traders to hold or stay too long in the losing position and not exit the winning positions too early. This rule or advice is considered by many to be the Holy Grail.

The reason that most of the traders end up on the wrong side of the trade is that they tend to do the opposite. Most traders sell the stocks after a marginal gain only to see their prices move higher and hold onto the losing stock for too long only to witness a further decline in the price. The art of cutting the loss and riding the profits is a hard skill to master. Only a few traders who have applied this art effectively are seen as the height of success in the world of capital markets. The idea is to make trades that will help you stand out from the crowd and make an appropriate trading decision.


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Here are some of the important things one needs to understand to ‘cut losses and ride profits’.

1. Know that Stocks Don’t Always Rebound

It is seen and believed that the stock index will always end up higher in the long term. But this might not be true for every individual stock. Many companies in the downslide may never again go past the previous high and might even go bankrupt. So it is foolish to always expect a rebound for every stock in the market. Some do but not all. Moreover, when the market goes bearish after your buy, it might take years to recover if they eventually recover. In this case, the return on your investment is minimal or none.


2. Accept the Blame

It is not uncommon among traders to not accept they made the wrong choice or decision and try to hold the stock out of ego to prove themselves right. This mentally drags one to the emptiness. It is an illusion to think a loss occurs only when sold in a losing position and expect to sell when they break even. Unfortunately, time is money. A stock’s rock bottom is hard to predict when it is rolling downward with gravity. It is wise to accept the judgment error and make a sale with minimal loss.


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3. Set Stop-loss

Stop-loss is the key arsenal at your disposal to cut losses. A setting stop-loss will help you get better off your emotions and limit the losses. It is often advised to apply stop-loss for a volatile stock.


4. Would I Make a Buy Now?

When the stock prices are falling, ask yourself “If I didn’t own the stock, would I make a buy now?” The answer to this question will simply tell you whether you should sell or hold onto the stock.


5. Set High Reward-to-risk Ratio

Aim for the big profits but exit with small loss. Suppose you set a reward-to-risk ratio of 3:1, you just need one stock to perform with 25% profits to break even for 3 losing stocks. This allows you to come back even if you make wrong trades a couple of times.

It is not easy to make 50% right trading decisions. Most of the time traders are wrong but successful traders make most of their winning positions making huge profits. It is true that ‘it is not how often you win that matters most, but how much you win once you hit that winning trade.’

Since trading is a long-term and continuous process based on statistics (no luck), possibilities (not gut feelings), a successful trading strategy is evaluated over a specific period of average trades. Losing in the stock market is inevitable and losing in single trade doesn’t matter as long as you can minimize loss. Profiting by averaging the total trades is the way to look towards successful trading.

In the book ‘Market wizards’ by Jack Schwager, the great Peter Brandt (CEO of Factor LLC, a global trading firm) has said he presumes that while making trading decisions he will be incorrect around 65% of the time. That’s quite several failed trading decisions but he has been able to make millions for his firm which is only possible through ‘cutting losses and riding profits’.


Conclusion

“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – Warren Buffett

The stock market is not a fast lane to get rich. The volatile market is a cycle of profit and loss, a fight between the Bulls and the Bears. While avoiding the loss might not always be possible but minimizing the losses is certainly in your hands. Setting stop-loss and profit targets are essential to being a successful trader. One can make a fortune even with a higher loss–win ratio when the rule is applied while trading in an unpredictable market.

From The Author:

7 Best Risk Management Strategies for Traders

5 Best Trading Strategies for Stock Traders

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