Taking small losses while you can

Here is an example of a recent set up which made it onto our watchlists, and shows the folly of failing to take a small loss when you could have.

This is a US stock which had a clear line of resistance during 2014, as shown by the drawn line on the chart below. Finally, in late August price started breaking out. Initially price move in the intended direction before starting to reverse about 10 day later.

Due to the stop methodology we use, we aggresively cut any trades where the breakout fails, such as in this case. We are trading breakouts, therefore it price falls below that breakout level, then the reason for staying in the trade is no longer there.

As a result, we would have avoided riding the stock all the way down to where it is now. We would also have avoided taking a full -1R loss on the trade, getting out with possibly a -0.4R loss on the trade.

The stop methodology we use is a more extreme version of what David Ryan talked about in his Market Wizards interview with Jack Schwager.

I had one such instance myself this week - the trade broke out on Thursday and ended the day in profit, initially tried moving further up on yesterday's open before reversing and failing just before the close.

This sort of trade failure is an extremely common occurrence when trading breakouts, therefore we are used to having lots of small losses, and have the discipline to cut the trade and move on. However, a lot of inexperienced traders don't. They will hold on, in the hope that the price will reverse, only to see the losses start to increase as time passes.

Yes, you can get whipsawed on occasion around doing this. But, you completely take out of the equation the possibly of a small loss growing into a much bigger one. Capital preservation keeps you in the game, and avoiding major losses helps you achieve that..