Many stock investors wrongly believe that their work is finished once they buy the shares of their choice. The rest is just to wait for returns or let the dividends roll in.
Nothing could be further from the truth. The difficult work starts after you buy a stock. The steps you take after buying stock or securities can mean the difference between a well-earned profit and a disappointing loss.
Usually, you will have bought a stock for a particular reason. However, it is important to realise that stock prices are affected by many factors.
Therefore, the price may unexpectedly go up or down significantly. This may mean you miss a good opportunity for good gains or suffer loss respectively. So, what can you do to increase your chances of gain and minimise loss?
Two strategies commonly used to guide your position to a profit or keep the loss as low as possible are pyramiding and cutting loss.
Before you start in this trade, you should have decided on your target price if the market favours you and your stop-loss price in case the market goes against your expectations.
If the stock price continues to favour you, you can cash out in stages by reducing your position as the price rises. This is called pyramiding or easing out. Of course, you should have decided on your first target exit position even before you bought the stock.
The first exit position should be at a percentage gain you are comfortable with.
Some people may decide to sell half their shares once a gain of 15 per cent is reached. Others may do so at 20 per cent or more. A 15 per cent is a good starting point because it is above bond rates and inflation combined.
At the second exit, you may sell half the remaining stocks, and if the price continues to rise, you can wait to sell the rest at a higher percentage.
By doing this, you will have continuously reduced your risk. Unless you are executing a “one and done” strategy that enters and exits 100 per cent of your position, pyramiding provides an excellent tool to manage changing risk by taking money off the table at regular intervals during the rise.
When people buy stocks, they rarely think about losing, yet gaining and losing are two sides of the same coin. Most traders and investors focus on gaining alone.
The reality, however, is that anyone can lose money in the market — whether one is a seasoned investor or beginner.
What usually separates the winner and loser is the aspect of cutting losses in a small way. Cutting losses is by selling your stocks at a predetermined price, which is usually termed a stop-loss.
Preferably, the stop-loss should not go beyond 10 per cent loss. Under 10 per cent, the percentage increase needed to get back to even is more or less the same.
Beyond 10 per cent, the percentage increase needed to get back to square one starts going up rapidly.
The higher the loss you allow, the harder and more time it will take to get back to even. What a waste of time and exposure to anxiety?
Before you buy a stock, therefore, it is important to know the price at which you will exit should the market go south. That way, the market never gets you unprepared.
More than anything else, the failure to cut losses is what has led many to financial ruin in the stock market. People just watch prices going down without taking action.
They stick to the hope that the market will reverse and move in their favour. Hope is not a strategy in stocks. In addition, there is no guarantee that a stock that has gone down will not drop further.
Those who are aware of this fact always cut their losses small. They know they can always buy back the stock further down should they still be interested.
After all, the fact that you have exited a stock does not mean you cannot buy it again. William J. O’Neil, the author of How to Trade Stocks, says “the whole secret to winning in stocks is to lose the least amount possible when you are not right.”
To sum it up, George Soros, a Hungarian-born American billionaire investor and philanthropist says; “It is not whether you are right or wrong that is important, but how much you make when you are right and how much you lose when you are wrong.”
Pyramiding and cutting losses are two money management strategies in stock trading that will greatly increase your probability of success in stocks while at the same time protecting your capital and the gains made.
Respectively, they offer the offence and defence strategy required to win in stocks.