How to cut losses in trading: The importance of knowing when to exit a position

Losses are an inevitable part of trading whether you buy an asset or sell it. Knowing when and how to cut losses in trading quickly is one of the most important skills to master as a trader.

Let’s explore the importance of cutting your losses in trading. We’ll provide insight into the cut your losses meaning, as well as what it means to cut your losses.

In addition, we will offer useful tips on how you can determine the right time to close a trade so you can cut your losses and manage your losses better.

Why you should know how to cut losses in trading

In trading, protecting your portfolio is just as important as making consistent profits. Learning how to minimize your losses is fundamental to this principle.

Cutting losses in stock trading generally means knowing when to close a losing position. If an asset’s current price is lower than your purchase price, you’re incurring a loss and should look to exit the trade to avoid losing more money. It sounds simple, but the reality says otherwise.

Psychological aspects of cutting trading losses

Even seasoned traders can experience significant trading capital loss from time to time. These can occur due to various factors, including market volatility, poor trading decisions, or unexpected news that have a ripple effect across the market.

Accepting the inherent nature of a losing investment is the first step toward controlling downside risk in trading.

However, what sets successful traders apart is their ability to keep their losses small and infrequent. They acted fast and decided to cut losses. This is key because the longer you hold on to a losing position, the more capital you lose.

Related: Why Trading Psychology is Crucial for Trading | markets.com

Why is it difficult to cut your trading losses?

One of the most common reasons for this is being too emotionally attached to a trade. More often than not, we find ourselves in situations where we hold on to a losing position hoping that the market will turn in our favour.

Such was the case for several traders who unwittingly incurred heavy financial losses during the COVID-19 pandemic because they didn’t close their positions on time.

Another common reason is that we simply don't want to accept the reality.

No one wants to sell for a loss. It’s throwing away the hope of making money in case the market rebounds over the next few trading sessions. Plus, it is an admission that we made a poor trading decision, which is not always an easy thing to stomach.

Lastly, we often fail to cut our trading losses due to the fear of missing out (FOMO). Perhaps there’s a lot of hype about a stock so instead of exiting the losing position, we hold on to the detriment of our portfolio.

The best way to avoid holding on to a losing position for too long is to understand that the earlier we accept a loss, the less money we lose.

How to cut trading losses in the market

The bottom line is it all comes down to knowing when to exit a trade. However, there’s no way to know for certain when to close a position.

The market is unpredictable, so there’s no telling for sure if a losing trade can rebound and lead to short-term capital gains over the next hour.

That said, professional traders often rely on several risk management tools and market data to help them determine when to exit a losing trade and sell stock at a loss. These include:

Stop-loss orders

A stop-loss order automatically closes a trade when the stock price reaches a predefined level. When you set stop losses, it helps you limit potential losses, ensuring you exit a trade position at a predetermined threshold.

In this way, a stock trading stop loss order helps cut your losses and protects your capital.

A popular variation of the stop-loss order is the trailing stop loss. With this tool, you not only cut trading losses but also lock in profits. It adjusts the stop-loss level based on the stock’s price movements.

For example, if you set a trailing stop loss order with a 5% distance and initiate a trade at £100 per position, the initial stop loss level would be set at £95. If the price rises to £110, the trailing stop loss order would adjust to £104.50 (5% below £110).

However, if the price then declines and reaches £104.50 or lower, the trailing stop loss order would be triggered, and the trade would be automatically closed to limit the potential loss under normal market conditions.

Your trailing stop loss order will also be closed if the price moves in the other direction by a specified percentage or value.

Technical analysis indicators for cutting losses

You can also use technical analysis tools such as moving averages, trendlines, and oscillators to help you identify market trends and patterns.

For example, you can use channels and trendlines to identify potential areas of support and resistance levels. These are great for setting entry and level points in day trading.

Let’s say the price fails to break above a major resistance level. That’s usually a sign to close your position because the price is likely to drop.

Fundamental indicators

Some popular fundamental analysis factors to consider when cutting trading losses include company financials, industry trends, and macroeconomic indicators.

These fundamental factors provide useful insight into how a company is faring, which in turn impacts its stock performance.

For example, the stock prices of companies in the aviation industry plummeted due to the travel restrictions imposed by the Covid-19 pandemic in 2020/2021. That would have been a terrible time for traders to still hold on to their stocks.

A sound trading strategy

A proper trading strategy clearly outlines entry and exit points, how much you’re willing to risk, and your trading goals.

Staying committed to your strategy can be difficult when market conditions are unfavorable. While it doesn’t directly cut your trading losses, having a good trading strategy helps you avoid reckless, emotion-driven decisions that can result in losses.

Continuous learning

The stock market is dynamic, and market trends can change rapidly.

If you want to become a better trader, continuously invest in knowledge and skills by reading books, attending webinars, and taking trading courses. This helps refine your perspective of the market and allows you to get a better idea of when to exit trades on losing stocks.

At the end of the day, cutting losses in stock trading is crucial for long-term success. While losses are part of the trading process, you should be proactive about finding ways to minimize their impact.

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Risk warning: CFD trading involves risk and may not be suitable for everyone. Ensure you fully understand the risks involved and seek independent advice if necessary. This blog post was written for educational purposes only and should not be considered financial advice.