The value of your account trumps everything else going on in the market, at all times. Protect the value of your account. If you are wrong, admit it, get your money off the table and start over. You will have a comparatively higher value to resume compounding from. And from experience, once you go to cash, you’ll have more clarity and a big old smile on your face having no current market exposure. Also, you are always pickier when selecting new investments after having gone to the sidelines.
Stop orders should always be used to protect profits and limit losses on individual positions, thereby limiting a drawdown in the account. 9 out of 10 times they work as designed, with the 1 out of 10 times being attributed to a limit-down scenario on the open. In this rare case, your stop would be triggered at the open, immediately becoming a market order, and your stock would be sold at a price worse than you anticipated.
I should be clear about what I mean by “rare.” Percentage-wise, it is a risk you take, but if you spend enough time trading, this will happen to you. That’s why you always trade with as much discipline as possible – all the little things you do to protect the money-line along the way matter. One day the market will be unfairly unkind to you, and if you’ve made or saved money along the way those dollars will act as a cushion. Also, you could use stop-limit orders, but this adds another level of complexity and does not guarantee your order will be executed.
This is why you need someone to watch the account full-time so that when they come into the office in the morning and see a piece of news affecting a position to the point that the bid-ask spread is lower than the stop, they can at least consider canceling the stop order and wait for the inevitable bounce off of the bottom (immediate-term support) to sell into, or perhaps the stock finds strong support and finishes ok. Always, always, always have a stop somewhere below your position. The exact location of this stop is subject to best judgment given account, geopolitical, market, sector, and individual stock analysis.
You can also use options to protect the account. You can use options for a lot of things…. they are quite handy – they carry fairly low transaction costs, they can help you better manage overall risk, or they could help you generate income. You can tell a lot about an “advisor” by the way he reacts to questions about using options to generate income, to hedge, or to speculate – the fun stuff. You can tell even more by watching the mistakes he makes with your money while he pretends he knows what he’s doing. There are different levels of options expertise – beginner, intermediate, and like five or ten different tiers of advanced.
RM ~Feb 2011
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