This is actually the sister rule to letting your profits run, and is usually just as difficult to do (even if it is very easy to define). In the same way that profitability comes from a few large winning trades, capital preservation so comes from avoiding the few large losers that the market will see fit to send you each year.
Setting a maximum loss point before you enter the trade so you know ahead of time approximately how much you are risking on this position is pretty straight up.
You just have to have an exit price that tells you that your trade is a losing one you should exit before it gets any bigger. Because of gaps at the open, or limit moves in futures we can never be 100% sure that we can get out with our maximum loss, but simply having the rules, and always sticking to them will save us from the nasty trades that just keep on going against our position until we have lost more than many winning trades can make back.
If you have a losing position that is at your maximum loss point, you should just get out right away. You can’t hope that it will turn around. I never let a loss exceed 8%.
Being that trades are either winners or losers, and this one is shouting ‘Loser?at you, the chances that it will turn around and become a large winner is decidedly small.
Why would you want to risk any more money on a trade that has already shown itself to be a loser when you could simply close it out (accept the loss) and move on. This will leave you in a much better place financially and mentally, than holding on to your position and hoping it will go back your way.
Even if it did do this, the mental energy and negative feelings from holding the losing position are just not worth it. this is why you should always stick to your rules and exit a position if it hits your stop point.
This article written by Tim McGovern. You can read Tim's stock selections and trading/investing ramblings on his blog http://45Tips.com