Stick to Your Stop-Loss Plan

I knew that if I could keep all of my losses small, no questions asked, figuring out how to make money consistently in the market would eventually come together. At the least, I would not financially hurt those investors who had the faith and trust to let me invest their money in the stock market.

If you are new to trading in the stock market, listen up. If you do not have a stop-loss plan in your trading strategy, take a moment now to kiss a good chunk of your investment money good-bye. Selling a position within days of your purchase (I’ve literally done it within minutes), isn’t a very easy or comfortable thing to do. Frankly, it sucks out loud. But I found there is only one magic pill to success in the market: winning traders make small mistakes and take small losses, while losing traders make disastrous mistakes. If you have a proven strategy, the winners will eventually take care of themselves. That’s it. Nothing more, nothing less.

One of the questions prospective investors in my hedge fund have to answer is: “Can you afford a complete loss of your investment?” Interestingly, every one of my investors answered “yes” to this question, which is a good thing in running a money-management business. More importantly, to this day, a strict, stop-loss discipline is still paramount to my success in the market. I would have no problem taking on a new investor who actually answered “no” to the question. Cutting my losses has become so ingrained in my daily investment strategy that I do it without hesitation.

Can you get whip-sawed by cutting a loss? (If you are new, the term “whip-saw” basically refers to a position that moves higher after stopping you out for a loss). Absolutely. I can’t tell you how many times this has happened to me. Sometimes I can quickly get back on the position before it becomes hugely profitable. Other times the position becomes profitable for everyone else but me. At least that’s how it feels. But you can’t take it personally.

Take the recent example of PMC Sierra [PMCS>PMCS]. After purchasing this leading semiconductor manufacturer breaking out from a 12-week cup-and-handle base at 113, I was stopped out of my position two weeks ago at 104 for an 8% loss. Lo and behold, that was about 3 points above its pullback low. The stock rallied to a high of 148 1/4 Thursday and all I could do is watch from the sidelines like a deer stuck in headlights. Could I have gotten back on board on the renewed rally? Sure. But I lost my confidence in the stock’s trading pattern. At a time when most leading stocks have worked extremely well on breakout moves, I questioned why PMCS pulled back so hard into its basing structure.

It happens. It’s the insurance you pay for protecting capital in the long run. Think of it this way: If you own your home, you most likely have homeowner’s insurance and pay an annual premium. If your house doesn’t burn down, do you get upset that you wasted money paying your insurance premium? Of course not.

Here’s an example where stop-loss insurance paid off and occurs more often playing the breakout move than the occasional “whipsaw.” Access Health [ACCS>ACCS] was purchased around 58 on Aug. 27, 1996. Three days later I was stopped out around 63 for an 8% loss. Oh well. But eight months later, the stock resided at 13 5/8 — 78% lower!

Maybe you would’ve sold it somewhat lower than I did, avoiding an even steeper loss. Or maybe you would’ve been too caught up in some story about the company to sell at all. Get the point? This would’ve turned out to be a disastrous mistake that could’ve been avoided. The first loss, say 8% below your cost, was the best loss to take. It’s not always easy, but learn to feel the personal power that goes with adhering to a decisive stop-loss plan. It’s just part of the plan.

Looking at current market conditions, the market’s leadership remains intact with, albeit selectively, leading stocks breaking out from multiweek basing patterns every day and following through higher. Last week, Affymetrix [AFFX>AFFX], Qlogic [QLGC>QLGC], and Immunex [IMNX>IMNX], to name a few, all broke out from solid basing formations and followed through to higher ground over the next several days. Moreover, of those market leaders that broke out from long basing patterns recently, including Inktomi [INKT>INKT], only one leading stock that I track has actually begun to break down technically – RealNetworks [RNWK>RNWK].