Setting a Limit for Losses in Your Trades and Investments

Table of Contents

• Introduction
• Why Loss Limits Matter
  • Prevent Financial Ruin
  • Manage Emotions
  • Force Reflection
• How to Set Your Personal Loss Limit
  • Base on Finances
  • Factor in Risk Appetite
  • Common Rules
  • Set Firm Ceiling
• Specific Loss Limit Tactics
  • Per Trade Loss Caps
  • Trailing Stops
  • Time-based Exits
  • Option Collars
• What to Do If You Reach Your Limit
  • Step Away
  • Reevaluate
  • Seek Help
  • Reset Bankroll
  • Modify Limits
• Conclusion

Introduction

Losing money in the stock market or through active trading can be emotionally and financially devastating if losses spiral out of control. That's why it's absolutely critical for every trader and investor to set a firm limit for the total losses they are willing to accept.

"I lost over $50,000 in bad stock bets over the course of a year. It put me into serious credit card debt that took a decade to pay off." - Steve D., trader

As the above quote shows, lacking a stop loss plan can spell financial ruin. This blog post will explore the vital reasons why loss limits matter, strategies for how to set them based on your personal finances and risk tolerance, specific loss limit tactics you can implement, and what to do if you hit your previously defined maximum loss amount. Mastering loss limits is a key component of lasting trading success. Let's dive in!

Why Loss Limits Matter

Defining an absolute limit for losses is crucial in trading and investing for several reasons:

Prevent Financial Ruin

First and foremost, having a loss limit helps prevent catastrophic financial ruin. By capping your losses at an affordable level aligned with your overall income and lifestyle expenses, you can trade and invest with greater peace of mind. If your losses begin mounting, you have a plan already in place to contain them before they devastate your finances entirely.

For example, letting losses run unchecked could drain your trading account down to zero. But even worse - it could create substantial debt if you are trading on margin or have other costs basis. Define your loss limits around what you can afford to pay back if the worst case scenario happened.

Bob, a software engineer making $150,000 per year sets his maximum loss limit at $15,000 for the year. This represents 10% of his income. While losing $15,000 would still be painful, it would not completely derail his finances.

Manage Emotions

In addition to guarding your wallet, having a defined loss limit takes emotions out of the equation. After facing some losing trades, it's tempting to want to chase losses or average down in a desperate attempt to recoup that money. A loss limit removes the biased thought of "It's too late to quit now."

By spelling out ahead of time under what conditions you will cease trading/investing, you can make that decision objectively, rather than in a moment of panic watching your money evaporate. Remember - good money management isn't about making the most money, it's about keeping the most money.

Force Reflection

Finally, hitting a loss limit acts as a forcing function to reflect on why your trading strategy is failing and make necessary adjustments. Without a loss maximum, a trader could continue employing a faulty strategy indefinitely, chalking losses up to "bad luck."

Reaching your defined tolerable loss amount provides concrete proof that your current system does not work and must be fixed. It prompts essential self-analysis like reviewing losing trades, understanding consistent errors, obtaining more knowledge, and formulating an improved plan of attack.

After breaching her loss limit of $2000 year to date, Julie goes back and reviews past trades, realizing that holding onto losing stocks too long has been draining her account. She sets a rule to cut all losses at 10% going forward.

Now that you appreciate why setting a firm loss limit is non-negotiable, let's explore how to determine your personal loss limit based on your financial situation.

How to Set Your Personal Loss Limit

Choosing your individual loss limit should factor in multiple elements - your overall income and expenses, risk appetite, common best practice rules, and whether you will cease trading temporarily or permanently upon reaching that threshold.

Base on Finances

Your current finances - specifically disposable income left over after regular expenses - should guide your selection of a loss limit. Ultimately you want to choose an amount that you can afford to lose without compromising your ability to cover necessary spending like housing, food, healthcare, etc.

As a general rule of thumb, your loss limit should represent 1-2% of your total liquid capital that you have designated for trading and investing.

For example, if you have $50,000 you plan to put into market assets, you should set a loss limit no greater than $1,000 (2% of $50,000). Size your limit to your bankroll - a fixed dollar amount like $1,000 may be devasting or negligible depending on the size of your account.

Be disciplined in separating trading capital from “untouchable” money needed to live on. Never put rental money, emergency funds, or cash set aside for a house down payment at risk. Consider trading profits as extra, discretionary funds.

Factor in Risk Appetite

Are you an aggressive trader who loves volatile assets like penny stocks or biotech companies? Or a conservative investor focused on blue chips and index funds? Your personal degree of risk tolerance also plays into your loss limit number.

More aggressive traders may utilize a higher loss limit, like 5% of total capital at risk per month. Conservative investors playing it safe stick to 1-2% of capital at risk per year. Evaluate your personality and style.

There are no universal loss limits guaranteed to work. Day traders using leverage tolerate larger swings vs longtime shareholders compounding gains slowly. Match the limit to your unique attributes.

Common Rules

While every trader must determine their own acceptable loss threshold, these rules of thumb provide a starting point:

• 1-2% of total capital at risk per trade
• 5-10% of total capital at risk per month
• 10-20% of total capital per year

So for example, if you have a $20,000 trading account, limit each individual trade to 1% = $200. In a month, allow losses to accumulate to around 5% = $1000. And over a year, be willing to lose 10-20% or $2,000 - $4,000 total.

Again these are just guidelines - you may be comfortable with a higher or lower percentage based on your income streams and risk appetite.

Set Firm Ceiling

The final aspect in setting a loss limit is defining what happens when you actually reach that previously determined point. Will you immediately cease all investing and trading temporarily until you identify issues in your strategy? Or is hitting your loss mark the cue to walk away permanently and try a different endeavor?

You have to remove all emotion from this decision point. That means after losing $1000 in a day, you do not let anger and frustration motivate you to start dangerously averaging down. Follow the loss limit rules you made under calm conditions. Allowing losses a little beyond your limit can quickly snowball.

Now that you know how to create your personalized loss limit, let’s explore proactive tactics to actually implement that limit...

Specific Loss Limit Tactics

The previous section outlined a process for settling on a fixed dollar amount you can afford to lose across your trades and investments before feeling financial strain and being forced to reevaluate your participation in the markets. This dollar amount forms what we will call your Maximum Loss tolerance.

But simply saying “I am willing to lose $1000 this month from my trades” does nothing to actually ensure losses do not exceed that amount. You need to enact specific loss limit tactics per trade which cumulatively result in staying below your Maximum Loss threshold. Below are some top strategies to employ:

Per Trade Loss Caps

The most straightforward loss limit tactic is capping how much you are willing to lose on each individual trade you place. This per trade loss limit should correlate to the overall Maximum Loss limit you have defined.

For example if your Maximum Loss is $2000 per year and you execute around 20 trades per month or 240 trades per year, then your Per Trade Loss Limit should be approximately $2000/240 = $8.33 per trade.

So if you purchase 100 shares of stock ABC at $10 per share, or $1000 total dollar investment, you would set a Per Trade Loss Limit of approximately 8%, meaning you will sell the position if the share price drops to $9.17.

The 8% loss limit here makes sure that even if you lost 8% on every trade the full year (all 240 trades), those losses would accumulate to 240 * $83 = $2000, keeping you below your Maximum Loss.

Trailing Stops

A trailing stop loss automatically sells your position if losses reach X% from the peak price minus transaction cost. This constantly adjusts the stop level higher as prices rise.

For example, if you buy stock at $100 per share with a 20% trailing stop, if the price drops to $80 = 20% lower than the highest point of $100, the position is automatically closed.

Properly sized trailing stop losses encourage winners to run while quickly moving to lock in gains if trend reverses. Continuously trailing your cost basis higher protects profits while ensuring losses cannot spiral past X%.

Time-based Exits

Another simple yet effective stop loss tactic is setting a firm time limit for how long you will hold onto losing trades before closing the positions.

For example, you could set a hard rule to exit all trades that remain 5% or more below your entry price after 3 weeks. This contains losses on trades that are simply not working out while freeing up capital to put into new opportunities.

Time-based loss limits are often easier to implement emotionally since the decision rule is completely detached from price movement.

Option Collars

Collar options strategies involve simultaneously buying protective puts and writing covered calls on positions you already own. This hedges against downside losses past the put strike, while allowing some upside until shares are potentially called away at the short call strike.

For example, if you own 100 shares of XYZ stock at $50, you could buy a $45 put, protecting downside below $45, and write a $55 call, collecting premium while obligating you to sell your shares at $55 if called.

This limits total loss to around 10% downside, while letting you profit on rises up to 10% as well. The key is picking the optimal strike prices for the put/calls based on your loss tolerance, upside targets, and option premium costs.

Now let's switch gears to discuss what actions you should take once losses actually hit your predefined disaster point...

What to Do If You Reach Your Limit

Despite your best efforts at risk management, you may still breach that maximum loss threshold which requires a major shift in strategy. Here are constructive actions to take once you hit your limit:

Step Away

First, immediately cease trading after hitting your loss amount. Shut it down and step away for a set period of time like 60 days. The brief cooldown lets you process events calmly. You want to avoid destructive actions like attempting to recoup losses quickly.

Reevaluate Everything

Treat hitting the loss limit as an important learning opportunity forcing you to identify flaws in your trading approach. Rigorously study your losing trades and discern any common themes producing repeated losses.

Were most losses from low liquidity small caps? Holding through earnings reports? Buying at market open? Not using stop losses? Find your weakness and improve.

Seek External Help

An outside opinion can provide an invaluable neutral perspective. Consider hiring a trading coach, taking a class, or consulting with a financial advisor to review your strategy.

Having an experienced professional evaluate your trades, portfolio, and risk management framework can reveal overlooked missteps sabotaging you.

Reset Bankroll If Continuing

If you believe in your core strategy and process after reevaluation, the next step may involve funding your trading account back to its original level with an amount you are comfortable putting at risk. This resets the loss limit back to the full threshold.

Of course, only deposit additional funds that will not compromise your broader financial stability. Never throw good money after bad out of sheer emotion.

Modify Loss Limits

Alternatively, persistently hitting loss limitsmay signal trading does not align with your skills and interests. Reaching your maximum acceptable losses repeatedly likely means your strategy is not profitable long run in the markets.

Revisit if this activity remains right for you. Consider shifting loss limits even lower, scaling back position size, or trying a new investing approach better matched to your strengths. Know when to walk away if losses exceed your means.

Conclusion

Setting a firm limit for the total losses you can endure helps contain financial risks and prompts important self-reflection when hit. Carefully consider your income, existing assets, degree of risk tolerance and future earning potential when defining maximum loss thresholds. Enact per trade stop losses, trailing exits, time-based sells, and option collars to proactively honor loss limits. If losses still hit disaster level, step away, reevaluate everything, get help, reset bankroll, or walk away.

While hard to implement emotionally, Having the discipline to cut trades and investments at a predetermined point is key to surviving as a trader over the long haul. Define your loss landscape now before you face heat of the moment decisions.

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