Two ways to protect your money

Many stock investors wrongly belief that their work is finished once they buy a stock. The rest is just to wait and let the profits roll in. Nothing could be further from the truth.

In fact, the actual work starts after you buy a stock because the steps you take after buying can mean the difference between a well-earned profit and a disappointing loss.

Usually, you will have bought a stock based on a particular reason. However, it is important to realise that stock prices are affected by many factors.

The price could unexpectedly go up or down significantly without your knowledge in which case you will miss a good opportunity for good gains or suffer heavy loss. So, what can you do to increase your chances of gain and minimise loss?

Two strategies, pyramiding and cutting loss, are commonly used to guide your position to a profit or mitigate the loss.

Before you enter a trade, you should have decided on two critical prices; your target price if the market favours you and your stop-loss price in case the market goes against your expectations.

Pyramiding

If the stock price continues to favour you, you can cash out in stages by reducing your position as price rises. This is pyramiding or easing out.

Of course you should have decided your first target exit position even before you bought the stock. The first exit position should be a percentage gain you are comfortable with. Some people might decide to sell half their shares once a gain of 15 per cent is reached while others may do so at 20 per cent or more. 15 per cent is a good starting point because it is above bond rates and inflation combined.

At the second exit, you could 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.

Cutting losses

When people buy stocks, they rarely think about losing. Yet gaining and losing are two sides of the same coin. Many traders and investors focus on gaining alone.

The reality, however, is that anyone can lose money in the market, whether they are a seasoned investor or a beginner.

What separates the winner from the loser is the aspect of cutting losses small. Cutting losses is simply the act of selling your stocks at a pre-determined price, what is usually termed as 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 an even position is more or less the same. Beyond 10 per cent loss, the percentage increase needed to get back to square one goes 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, it is important to know the price at which you will exit should the market go against you. That way, the market never catches you unprepared.

Hope as a strategy

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 managing stocks. There is no guarantee that a stock that has gone down will not go down even further.

Those who are aware of this fact always cut their losses. 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, author of the book, 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 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 gains made. They offer an offense and defense strategy required to win in stocks. 

hustle@standardmedia.co.ke