Trading and Losses: When to Stop the Pain

In a recent blog comment and in a past post on his site, Bruce Berger asks the question about when to use stop losses as a value investor.  After all, if you believe an asset is a good buy at one price, surely isn't it a better buy 10% lower, 20% lower, 30% lower...??

The topic is relevant for those who have been long the stock market and now see weeks of gains evaporate in a couple of trading sessions.

When do you add to positions and achieve greater value?  When do you stop out of positions and preserve capital?

My approach to this issue is different from some, as I try to approach it both logically and psychologically.  Unlimited losses pose risk of financial ruin, but also risk of emotional ruin.  Losses--for a competitive trader--will always be annoying and upsetting.  They may even be painful at times.  But they should not be traumatizing.  

If you lose 50% of your capital, you need to double your money to get back up to high water mark.  Game pretty close to being over, because the risk you'd need to take to double the remaining capital would expose you to meaningful percentage drawdowns.  But if you lose 50% of your capital, you don't just return to markets cheerily swinging for fences to make the money back.  Losses of that magnitude have the same psychological impact as other significant losses:  they set us back emotionally as well as financially.

To protect your mind as well as your money, each trade has to be sized as a bet and each bet has to be expressed to keep you in the game.  You can limit risk through hedging, through the use of options, or through the use of stops.  Think of it this way:  Every trade expresses a hypothesis based upon an idea.  In essence, when you enter the market, you're saying, "Because of X fundamental/technical/statistical reasons, I believe we are going higher/lower and I am willing to risk A in order to make B."  The hypothesis is that you'll achieve the profit B before hitting the loss A.  

Those who stay in trades on an unlimited basis look only at the idea, not the hypothesis.  They are betting on being right, not betting on a specific market outcome.  When ideas are not expressed as risk-limited trades, the only stopout remaining is pain.  And that's not an outcome good for emotional or financial capital.

Further Reading:  Emotional Trauma and the Dark Side of Trading