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How To Know When To Cut Your Loss 

Last Updated: December 15, 2020

By Rayner Teo

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In today’s episode, you’ll discover when you should cut your loss (without cutting a hole in your pocket).

So tune in right now…

Resources

The Complete Guide to Stop Loss Order

How to Use Trailing Stop Loss (5 Powerful Techniques That Work)

Transcript

Hey, hey, what’s up, my friend? In today’s episode, I want to talk about how to know when you should cut your loss.

(I believe this is a topic that you might be struggling with, if not, you won’t be watching this episode.)

I’m going to share with a simple technique that you can use to know when you should cut your loss. But first, let’s talk about how not to cut your loss.

Mistake #1: Cutting loss based on feelings

Here’s the thing, if you cut your loss based on how you’re feeling, chances are, you’re cutting your loss when the market is at the absolute lows where the pullback is about to end and reverse in your favour.

When you can no longer take the pain anymore and you cut your loss, that’s usually when the market is about to reverse in your favour. Don’t cut your losses based on your feelings because that’s usually the worst possible time.

Mistake #2: Cutting loss based on the amount of trading capital left

What some traders might do is that let’s say their trading capital is $5,000, they’ll tell themselves, “I will cut my loss when my trading capital drops to $4,000.”

Now, here’s the thing, the market doesn’t care how much money your trading account is left with. It goes where it needs to go.

It doesn’t make sense to cut your loss based on the size of your account because the market doesn’t know the size of your account and it doesn’t care either.

Mistake #3: Cutting loss based on the news release

You shouldn’t cut your losses based on fundamentals’ news release because here’s the thing, by the time that new is released, the fundamentals would have already soured and you could lose a lot more on your trade.

Don’t wait for news to confirm whether you should cut your loss or not. Now you might be thinking, “Rayner, how do I know when to cut my losses then?”

If you’re a technical trader, meaning that you employ technical analysis to trade the markets, then one very simple technique to use is this…

Rule of thumb: Your stop loss should be at a level which invalidates your trading setup

I believe that quote is from one of the Market Wizards, Bruce Kovner. Basically, your stop loss must be at a level which invalidates your trading setup.

Let’s say your trading setup is buying a stock in an uptrend. And because this market is still in an uptrend, your stop loss should be at a level which invalidates that uptrend.

What does it mean? It means if the market reaches your stop loss, the uptrend is no longer valid. Does that make sense? Let me give you another example.

Let’s say you trade the double top chart pattern and you want to short the market. Now, where should your stop loss be?

Well, if the basis of your trade is just based on a double top chart pattern, then your stop loss must be at a point where your double top pattern is invalidated.

And that will be above the highs of the double top pattern. Because if the market breaks above the double top pattern, you can imagine that the pattern is no longer looking like a double top. Makes sense?

One more example. Let’s say this market a range market, contained between the lows of support and the highs of resistance. You buy low at support and sell high at resistance.

Let’s say you buy at the lows of support in the range, where should your stop loss be? Well, your stop loss shouldn’t be the middle of the range because, at this point, support is still intact, it doesn’t make sense to cut your loss when the price is contained within the range.

It only makes sense to cut your loss when the price breaks below the lows of the range. That’s where your stop loss should be. Your stop loss should ideally be a buffer below support.

Clearly, if the price breaks below support and hits your stop loss, that means that the range is broken and you should get out of the trade.

The key thing is that your stop loss must be at a level which invalidates your trading setup. If your trading setup is intact and not invalidated, then you shouldn’t cut your loss yet.

However, you want to cut it as soon as possible when your trading setup is invalidated. The key thing is to identify key areas on the chart where if the price breaks below it, your trading setup is invalidated.

For example, if you’re trading in a range, that area might be below the lows of support.

If you trade a moving average bounce where the price has been testing the 50 MA for the last two or three times, then if the price breaks below the 50 MA, that means the 50 MA is no longer holding up as dynamic support and you should also get out of the trade.

Hopefully, these few examples give you a good idea as to when should you cut your loss.

With that said, I wish you good luck and good trading. I will talk to you soon.

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