Understanding risk and reward
Planning your exit
Since no human can see into the future, unfortunately new and experienced traders alike will sometimes have to contend with losing trades.
Emotions can run high at these times. Watching your hard-earned money being depleted from your account is an uncomfortable experience - and it can compromise your decision-making abilities.
That's why it's important to decide - right at the outset - where you'll get out if this trade doesn't go well.
Rule 1: always have an exit strategy
You need an exit plan - a strategy for managing the risk of the position, so that one bad trade won't wipe out a significant chunk of your trading capital. But simply telling yourself where you want to get out may not be enough.
Consider the scenario: you head to bed for the night with a position going well, but by the time you wake up in the morning the market has taken a turn against you.
Or perhaps you're watching a position while travelling on the train. You enter an area with no mobile or wifi service, and by the time you get back online the market has moved past your planned exit level.
So once you’ve decided where you’ll close the trade, you need an automated mechanism to protect you when you’re not in control. And that’s our second rule:
Rule 2: set a stop
Setting a stop reinforces your exit strategy. The resting order will close your position if the market hits the level you specify, even if you're not logged in to your platform at the time.
It also removes the need for you to make a difficult decision under pressure.
It's easy to disregard the emotional aspects of trading. But, especially when you're new to the markets and still learning, the rollercoaster of feelings created by losing a trade can have a substantial impact.
Example
Let's say you take a long position and the market immediately starts to rise, putting you into profit. However, suddenly it goes into a sharp reversal, and to your dismay your winning trade rapidly turns into a loser.As the position drives further below your entry price, you keep hoping for recovery. But that hope turns into wishful thinking as prices continue to deteriorate.Finally, you're left with a feeling of desperation. It's clear that prices aren't coming back anytime soon, and you have no choice but to realise a loss.
In this situation, the financial impact certainly stings. But it's the emotional toll that can make your next trade more complicated, as you try to recover. Just one idea that didn't work out could define how you move forward in a market. For example, you might feel tempted to rush into a new position without proper consideration, in an effort to claw back your losses as quickly as possible.
One easy way to help avoid this issue is to decide where to set your stop before opening a position, and set it up while executing the trade, so your position is never left unprotected.
With a stop-loss order in place at your pre-defined exit level, if that price is met you don't have to make a decision about to what to do. You've done your planning in advance, and your position is closed for you.
Lesson summary
- Every trader needs to be prepared to suffer some losses
- Always plan where you'll exit a trade if it doesn't go well
- Set a stop to close the position automatically for you
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