Elements of a Successful Trading Plan--Cut Losses Short
If you are following market trends rather than trying to anticipate them, the next important part of the plan is how to exit trades that don't work out. Here is where the second cardinal principle comes in. It is Cut Losses Short.
This is another sensible-sounding concept that is much easier to acknowledge than actually to execute when real money is on the line. No one wants to exit a trade with a loss. They don't want to lose money. More importantly, they don't want to admit they were wrong. You can always think of many reasons to hold on to a losing trade. You can hope that the market will suddenly turn around and give you a profit instead of a loss.
This is another example where successful traders have learned to do the hard thing. If there is one thing consistent in the stories of how good traders turned themselves around from being bad traders, it is their attitude about losses. Professional traders accept that losses are part of the game. Since the markets are mostly random, the best trading methods will always have numerous losses. Professionals do not equate losses with being wrong.
It is precisely because correct trading methods invariably generate many losses that it is important to keep the individual losses small in relation to the overall size of the account. In order to keep trading, you must preserve your capital. If you can keep trading in the direction of the trend, the big profits will come. However, if you take too many large losses, your capital will be wiped out before you can enjoy the big profitable trades.
The laws of probability insure that regardless of your approach, you will inevitably suffer some long strings of consecutive losses. If you are risking too high a percentage of your account on each trade, before long one of these unavoidable losing streaks will blow you away. Keeping losses to about one percent of your account size is optimal. With smaller accounts, the percentage will have to be larger. Five percent on one trade is probably the highest prudent level of risk.
Because of the randomness in commodity price action, you must allow the market a certain amount of leeway before giving up on a trade. In general, you must be willing to risk between $500 and $1,000 to trade most markets. For smaller accounts, the Mid America Exchange offers trading with smaller sized contracts that allow you to trade with lower risk.
While there are more sophisticated ways to decide when to exit a losing trade, getting out after a loss of a predetermined dollar amount is as good a way as any. The important thing is to respect your plan. You can place a stop-loss order with your broker that instructs him in advance to exit a trade if the market hits your loss limit. You should always do this to guard against inattention or changing your mind at the crucial moment.
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