Financial Risk Management For Dummies

Chapter 11

Stopping Losses

In This Chapter

Setting stops

Sidestepping common mistakes

Adjusting stops

Checking the frequency

The American humourist Will Rogers had the best advice about how to make money in the stock market: ‘… Buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.’

For those of us who can’t figure out how to do that, the next best version is: if it don’t go up, sell it. This judgement is called a stop loss, and is perhaps the simplest and most powerful risk management technique. Selling holdings that aren’t increasing their value is an ancient practice borrowed and refined by modern financial risk managers. If you limit your losses to budgeted amounts when you’re wrong, you can survive long enough to collect the profits when you’re right – which is a reasonable definition of managed risk.

Understanding Stops

Unfortunately, most amateurs use stop losses in the precise opposite of the proper manner. They ask how much they can afford to lose or are willing to lose in a trade and set the stop loss at that point. This attitude ...