Cut your losses!   But where?

Limiting losses is an imperative for stock market investors and speculators.  A person who cannot cut their losses is doomed to huge losses to come.  And, it's not a matter of "if", but "when".  Through the magic of compounding, losses and gains are non-linear.  A 5% loss can be recaptured by a future 5.26% gain.  But, a 50% loss requires a future 100% gain, just to get back to breakeven.  And, a 100% loss can never be recaptured, as the position is wiped out.  Allowing losses to become large is a recipe for portfolio destruction.

Many have a difficult time selling a position at a loss, because 1) they do not want to lose money, and 2) they do not want to be wrong.  Well, the proper perspective is to realize that the loss has already occurred, and that is reality.  And, to realize that selling at the predetermined stop-loss price is part of the overall strategy, and thus, the RIGHT thing to do.  Deviating from the strategy to avoid accepting a loss is a sure way to big losses in the long run.

So, at what point must we pull the trigger and cut our losses?  Most investors determine their own pain points rather arbitrarily.  But, the optimum stop-loss point can be determined mathematically.  The model profit and loss plan depends on just two inputs: The ratio of your strategy's profit target percentage to its loss limit percentage (e.g. if your strategy has a profit target of 20% and a stop-loss of 10%, your ratio is 2:1), and your batting average (the percentage of time your strategy reaches the profit target before the loss limit).  This model ignores any trades cut short before the targets are hit, and assumes you can actually exit the trade at your target (no black swans or gaps down).  

This model can also identify strategies which are sure to be losers, where, even if the targets are hit, the strategy will lose money.

Use the sliders below to test a strategy.  Notice there is an optimum stop-loss limit along the return curve.  Then, mouse over the chart to see the returns at various limits.  Most importantly, notice that there is a point where, if the stop-loss limit is too high, the strategy is sure to lose, even with increasing gain percentages.  Don't let your losses run!