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A Cheap Way to Learn the Most Important Lesson in TradingBy Brian Hunt, editor in chief, Stansberry & AssociatesMonday, October 26, 2009 "The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you follow these three rules, you may have a chance." – Ed Seykota
Imagine someone rounded up the greatest golfers of all time, sat them down, and asked them how to become a great golfer.
Now imagine that all of them – Arnold Palmer, Ben Hogan, Jack Nicklaus, Tiger Woods, and so on – recommended using the same technique to achieve incredible success. Maybe they tell you to keep your head down or to keep your arm straight. If you wanted to become a great golfer, you'd probably make this technique your main focus.
This sort of thing has been done in the business of trading. You'll find it in the greatest trading book of all time, Market Wizards. This book is a series of interviews with some of the richest, most successful traders to ever live. It's also a series of stories about one trading technique, which Ed Seykota captured in the quote above.
The technique is cutting your losses. Of selling a position if it's not moving in your favor. It's the key to turning your trading into a lifetime builder of wealth.
Seykota is a legendary "trend following" trader that made himself and his clients millions and millions of dollars. His quote is a lot like the real estate cliché, "location, location, location." The idea of cutting losses is so much more important than everything else, it needs to be repeated three times.
Other legendary traders say the same thing... William O'Neil, the great stock trader and founder of the newspaper Investor's Business Daily puts it like this: "Letting losses run is the most serious mistake made by most investors." The great short-term trader Marty Schwartz puts it like this: "Learn to take losses. The most important thing in making money is not letting your losses get out of hand."
Now... it's easy to read all of this great "cut your losers short and let your winners ride" stuff. It's easy to repeat it to yourself while you're driving or lying in bed. But for many traders, the execution of this idea is difficult. Many traders just can't say, "Well, I'm wrong on this one... Time to admit it, protect my capital, and move on."
If you're one of these traders, here's a technique that could mean a lifetime of profitable trading...
Let's say you're trading a $50,000 account and having trouble cutting losses. When you look at your account statement at the end of the year, you see a series of large losses overwhelming your small winners.
Take a small portion of your total account – maybe $3,000 or $5,000 – and start trading a volatile sector of the market. Small-cap Chinese stocks, biotech stocks, or mining stocks work beautifully here.
Instead of placing your normal-sized position in these stocks, place just $300 or $500 into each trade. Use a stop loss of 10% or 25% on each trade. Make a lot of trades with this small "training account." When one of these trades goes against you, cut your loss and move on. You'll lose maybe $50 or $125 per trade.
Make as many of these micro trades as it takes in order to turn loss-cutting into an automatic reaction... just like throwing your arms out for balance when you slip on ice.
Practice loss cutting just like you would playing the piano and you'll get great at it. You'll know what the Market Wizards know... and you'll start acting like them. Wealth will follow.
Good trading,
Brian Hunt
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