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Don’t tailgate in the markets

August 31, 2016
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As featured in the Herald Sun – Friday 26th August 2016.
By David McCulloch – Market educator and consultant to Share Wealth Systems

Many newer investors have a tendency to become fixated on their trade entries, and to be honest this was also something that I fussed over when I first started many years ago. I realized after a period of time that the fuss should have been on the exits. Since then, my primary focus on assessing any new opportunity is….”where is the exit?”…….ALWAYS!

Most investors rarely give much consideration to the actual exit in the belief that they’ll instinctively know when to get out. You only need to go back to the GFC or to the next one, in order to see how that strategy worked out for them.

The methodology for exiting trades, in my opinion, is more important than the methodology for entering trades. Trade exits need to be designed to protect trading capital as the first priority. Trades should generally be exited as a result of one of the following events:

  1. Initial stop loss is triggered
  2. Trailing stop loss is triggered

A “hard” stop loss order is set to trigger at a predefined price on your trading platform. If the market price touches the trigger price the order will be automatically executed in the market in real time. A “soft” stop loss order also has a predefined trigger price, but does not have a corresponding order to transact on the trading platform. A soft stop order merely represents intent to consider a course of action if the market price closes below the trigger price. When a soft stop level is breached, and price has closed below it, the market is telling us that momentum has waned significantly and now places the stock at a much higher risk of further downward movement.

Setting the Initial Stop Loss:

A stop loss is a price at which you decide a trade is no longer valid. If this price is breached and the price closes below that level, you’ll need to immediately implement an appropriate exit strategy. A stop loss serves two purposes: firstly, defining the risk on an individual trade, and secondly, preserving the remaining capital to be used on the next potential opportunity. Each is pivotal to the longer term outcomes of your strategy and therefore an initial stop loss is really a must have on each setup you are considering, without exception.

When an initial stop loss is triggered valuable trading capital is lost. To protect trading capital, the initial stop loss should be set at a price where the stock is unlikely to move to based on its recent historical movement. Placing a protective stop too close is a common mistake for newer investors, mistakenly thinking that by doing so they’ll not lose as much money if things turn against them. A continuation of this practice often results in huge frustration and a commitment to not use protective stops or exit mechanisms at all. Understanding proper stop loss placement doesn’t need to be difficult and is the topic for next week’s article.

David McCulloch is a market educator and consultant to Share Wealth Systems

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