Keep Your Powder Dry Till Your Guns Start Blazing
By using this approach, we prevent ourselves from over-leveraging our positions and creating unnecessary stress. It also allows us to make several attempts to get into a position without risking too much money.
How many times have you been in a trade, got stopped out and then watched the shares skyrocket higher?
This used to happen to me a lot, but when I started using the "3% rule" approach, it enabled me to keep enough powder dry that I could make several attempts to get into a position until I got the trade to "stick," without murdering my capital.
At market bottoms and at market tops, this is a very savvy way of "probing" the market in an attempt to catch big, deep-trending moves without "betting the ranch."
As the position becomes profitable, I start adding to it so I can catch as much of the move as possible while always moving my stop-loss along with the stock price to protect my principal and accumulated profits.
What Happens if You Get Stopped Out?
I use a progressive system of investing, which means that, as I said before, as I'm winning, I progressively increase my position size. When I'm losing, I progressively decrease my position size.
If I'm making several attempts to get long on a sector and I keep getting stopped out -- but I still believe the sector is ultimately going higher -- I do things a little bit differently.
After the first trade is stopped out, I reduce the position size of my next trade attempt by 25%.
If that attempt ends in failure and I want to take a third attempt, I will decrease my initial position by another 25%.
If I want to take a fourth whack at the same trade, I'll decrease my position size by another 25%.
If I'm having several losing trades in a row, I institute this approach across all my new buys. Typically, if I have three losers in a row on three different stocks, I start cutting my position size. This way, I'm trading at my smallest when I'm trading at my worst.
Too many people do the exact opposite; that is, they actually trade more and in bigger size positions when they are losing. What they essentially end up doing is pyramiding their losses.
Here's what it actually looks like:
Let's assume we have a $40,000 account and, again, 3% of $40,000 is $1,200. Let's further assume that the initial position is 400 shares of a $20 stock and each subsequent attempt to purchase the stock is done with a $3 stop-loss.
If I have four wrong trades at 3% per whack, I will lose 12% of my starting capital, or $4,800.
If I use my progressive approach of reducing my position size after every loss, I will own:
| 400 Shares @ $20 - $3 loss = -$1,200 |
| 300 Shares @ $20 - $3 loss = -$900 |
| 200 Shares @ $20 - $3 loss = -$600 |
| 100 Shares @ $20 - $3 loss= -$300 |
| Total Loss = $3,000 |
By progressively lowering each new losing trade, I reduce my losses from $4,800 to just $3,000, or a very manageable 7.5% loss.
The 25% reduction in trading size is always keyed off the initial position size. So, on each attempt, I am reducing my position size by an additional 25% of the original 400 shares, rather than 25% of 300, 25% of 200, and so forth.
I use this same approach in reverse when pyramiding into a winning position. On each successive new purchase, I increase my position size by 25% while always maintaining a stop-loss that I move higher with my position.
Remember, losing stocks won't kill you in investing. Undisciplined position sizing, over-leveraging and trading without a stop-loss is what blows out most traders.
Nobody likes to lose money, but even in the best markets (and definitely in tricky markets like the one we're in now), your No. 1 goal is to live to trade another day. Losses are a fact of your trading life, but by limiting them with stop-losses and tailoring your positions to take as much risk off the table as possible, your discipline and consistency in adhering to the "3% rule" will ultimately pay off.
