Lessons from the Pros


Controlling Losses

I was watching a financial network on TV today and heard the anchor say, “Good news for investors in Zynga, the shares are up over eight percent today!” A little later she muttered almost under her breath, “But the shares are still down over 60% year to date.”

I do not mean to downplay the recent gains in the equity markets.  There have definitely been profits to be made.  The announcer’s comments just reminded me about how important money and risk management are to the financial survival of a trader or investor.

Losses are the only thing within your control when you enter the markets.  You may have done your research and planned the trade, but no one can know with 100% certainty whether the markets will move up or down and how soon.  So when you enter a trade, you decide several factors that will tell you if you are likely to lose and if so how much.

  1. Free Trading WorkshopThe market environment – Are you trading with or against the broad market?
  2. The stock’s trend – Are you trading with or counter trend?
  3. Gap risk – Will you hold overnight or over a weekend?
  4. Timeframe – Longer holding periods increase risk.
  5. Position size – How much risk are you willing to accept?
  6. Stop placement – How much are you willing to lose in the trade?

In our Professional Trader Course, we examine several odds enhancers that are part of your decision making process for every trade.  Failure to take these steps and evaluate every trade opens you up for greater and more frequent losses.

By understanding the risks in a trade, we can make adjustments to minimize the effect of losses on our account.  You can adjust the timeframe, use tighter stops, less share size, or even be more selective in the trades we take.

Looking from an investor point of view, being proactive in your investing allows you to avoid the large draw downs while enjoying steady returns in the markets.  Look at the yearly gains in the S&P 500 leading up to the credit bubble bursting.

  1. 2004 – 10.88%
  2. 2005 – 4.91%
  3. 2006 – 15.79%
  4. 2007 – 5.49%

Source: http://financeandinvestments.blogspot.com

That is a four year average of about 9.25% per year!  Not too bad.  Until you realized that 2008 suffered a whopping -37% return.   What if you had invested $100,000 in the markets in January 2004 and left the money there to compound?

  1. End of 2004 – $110,880
  2. End of 2005 – $116,324
  3. End of 2006 – $134,691
  4. End of 2007 – $142,085
  5. End of 2008 – $89,514!!!

So with one major draw down, you not only erased four years of investment profits, you also have less than what you started with in principal!  Even with the 2009, 2010, and 2011 gains of 26.46%, 15.06% and 2.11% respectively, your account is back to $132, 994.  Less than what you had during the peak in 2007.  You are also seven years closer to retirement from when you started.

Do not waste your time in the markets.  Be aware of the risks and use your education to manage them.  If you were an investor in Zynga, you watched as prices plummeted from a March high of $15.91 a share to recent lows under $4.  This is a tragic loss but one that can be avoided with proper risk management.  Where were the stops?  What about the old axiom of sell tech stocks in May and go away?  An Online Trading Academy graduate knows.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.