Why Limiting Losses are so crucial?

Limiting your trading losses is one of the four basic trading principles. But many traders, especially beginners, forget it. They place stop-losses but then lower those; waiting for market reversal. Often this market reversal does not occur and they have to close their position with high losses. Being optimistic they think that they can make up these losses with the profits from subsequent trades. This is a hard task; below is why.

Suppose you are trading with $10000 and a stop loss of 5% (at 9500). If you close your trade with a 5% loss ($500), you then have to earn back $500 to regain your original position, which is 105.26% of $9500. This 0.26% difference is often achievable. But when you lower your stop loss to 10% (9000); then you have to earn 111.1% to regain the original position. And when you lower it to 15% and 20%, then the money to regain becomes 117.6% and 125% respectively; 17.6% and 25% than you lost. This scenario becomes really unmanageable when you trade on margin.

One other thing that adds to your loss is your lack of diversification. When you are trading a handful of closely related stocks then your overall downside capital loss risk increases, because the prices of your investments can fluctuate in only one direction at a time. Costs involved in trading should also be considered.

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