Trading in the stock markets is not for the faint of heart. There are many potential pitfalls for those who are ill prepared to handle it, and you can fully expect that you will fall into some of those traps if you do not plan ahead.
While we all like to fancy the idea that we know exactly when to get into or out of a trade, this is simply not the case. No matter how smart or sophisticated we are human emotion always plays a role in trading. Watching money drip away often makes us want to press the panic button more rapidly than we should.
At the same time seeing increasing profits can give us a paralysis that makes us unable to take some chips off the table. This is why it is so important to go into a trade with a plan.
Before you ever place the trade you should be using your intellect and rationality to determine which investments look wise to you. You want to pick out something that appears to be at a bargain price compared to what its true value is.
Of course, this is exactly what everyone else in the market is doing as well and not everyone can be right all at the same time, so you must consider that you could be wrong on a trade as well.
Manage Risk With Hard Stops
In order to hedge the risk of being wrong while at the same time capitalizing on being right, a smart trader should put in limit and stop loss orders when he or she places the trade.
The limit is the higher price at which the trade will have their computer automatically place a trade to sell off the stock or other asset. At the same time, the stop loss is the lower price at which the computer will sell the asset.
The purpose being to define a set range of risk and reward before the original trade is even executed. For example, a trader may be willing to take a chance on a trade for a 20% profit but only want to suffer a maximum of a 10% loss if they are wrong.
Therefore, the trader would put in a limit price 20% higher than the current price and a stop loss price 10% lower than the current price.
Adjust Exposure As Trade Works In Your Favor
While this is a good strategy to start with, it can limit the big winning trades that we all dream about. Instead of restraining them and not letting the winners run, some have instead enjoyed the idea of adjusting those limit and stop loss orders as the trade starts to work in your favor.
In other words, if the trade is starting to run up towards that 20% mark in the example mentioned above, why cut it off at that point? Why not readjust the limit and stop loss points to the new price currently available in order to potentially get even bigger returns?
Think of it as working like this. You see an investment you like and you make the purchase.
Next, the price moves up 15% and you are happy that you have a winner, but you want to see just how far it can run. Instead of leaving your original 20% limit and 10% stop loss in place, you adjust it to the current 15% higher price.
Now you are still guaranteed of profiting at least a little, but you may see a very large profit. In other words, the worst you could do now is a 5% gain on your original investment (the 15% run-up minus the new 10% stop loss), but you could gain as much as 35% (the 15% run-up PLUS the new 20% limit).
Limit Exposure On Volatile Trades
Finally, when it comes to risky or volatile trades considering limiting your exposure. Do not put all of your chips on something that is far from a sure thing.
Maybe you put some money to work on something like that, but you don’t want to bet it all on something that can move rapidly in one direction or the other.
This is particularly true if you are using the stop loss and limit strategy as well. Volatile investments with that type of strategy often get stopped out quickly and the trader is simply out of some money then.
Just stick the basics and limit your exposure to the upside and downside for calmer, more predictable results.