Trading Tips - Preserve Capital First, Make Profit Second

Rule #1 - Preserve Capital First, Make Profit Second

Preserving capital has higher priority than increasing capital.

Preserving capital should be your first and foremost rule when trading stocks. When forces start to work against you, you will need to have a plan in place to protect your capital. Without capital you're out of the game.

One way to protect your capital is using a stoploss order. A stoploss order has a price trigger and a sell or buy condition, hence the order is triggered when a certain price is crossed, a long position is then sold and/or a short position this bought back. If the market never trades at the trigger price, the order is never executed.

You can choose between a market order or a limit order. Keep in mind, that if there is a market frenzy or panic like selling/buying, a limit order may not get filled why a market order may be far off from your stock price. The quality of execution depends on factors such as liquidity of the stock your trading and/or a possible gap in price movement. For example if a company reports earnings, the stock price may fluctuate after hours and open lower following trading day. If your stock price is higher than the opening price, and you have placed a market sell order, you will get filled at the current price which may be markedly lower than what you had hoped for.

Stoploss orders for long positions are placed below the previous low, while orders for short positions are placed above the previous high. The assumption is that if the market trades down during an uptrend and crosses the previous low, we will reverse and enter a downtrend. and vise versa, if during a down trend the market crosses into a new high, we have to assume the market just reversed into a new uptrend.

In case of ABB (see chart), a stop loss order would have locked in profit at around 24.50 and you'd be out when the stock hit a low of 16. Many traders with little experience often feel that they need to exit a long position near the top, and cover a short position near the bottom. If a trade goes against the traders vision, they hang on to a losing trade in hopes for the stock price to come back. This is a disastrous behavior, and often results in a total loss of their portfolio.

If the trade goes in your favor, the stoploss order will never be executed, and the stop trigger should be adjusted as the stock price moves higher (in case of a long trade). A convenient option many brokerages offer are trailing stop orders, which follow the price up with a cetain price cushion. However, the adjusted trigger price is not strategically placed anymore as it just follows the stock price.

When planning a trade, you should always look for large gain and small loss setups. We will talk about this concept in more depth in another article, but in this case a stop loss order should only result in a small loss, then we can learn from it, move on and focus on the next trade.