Using Stop Loss to Trade Penny Stock

Maybe you’ve heard the famous sports quote, “offense wins games, defense wins championships.” The same can be said for penny stocks: trades create riches, but defensive strategies keep your capital alive. An effective defensive strategy is crucial when the market decides to have a bad day and your position goes south. Your goal on some days has to be to live to see another day.

 

Amazingly, some traders won’t play defense because they think it gets in the way. They say that stop losses are dangerous and can ruin your strategy. While I’ll agree that stop losses can create more harm than good when not thoroughly thought out or well-placed, making the overall decision to avoid stop losses and money-management techniques is suicide for a penny stock investor. There may not be a more careless way to lose cash after completing a day’s worth of research, placing a stock on a watch list, and finally committing hard-earned capital to a trade, than to watch it all go away because you decided not to play defense.

 

Rather than ignore defense, let’s learn how to effectively manage your strategies, including the stop loss.

 

First, some general guidelines to strengthen your trading:

 

  1. Your first job is to preserve capital to make more trades. Remember that if you can survive a bad decision or a bad market, you’ll live to swing again. Stay focused on your long term goals, not today’s activity.
  2. Even the best poker players lose individual hands. Realize that every trade you make isn’t going to be a home run. To increase your average, you’ll need to cut losses quickly when things go against you. Don’t let your ego get in the way of good trading.
  3. A stop loss isn’t a perfect defensive weapon. If you decide to place a stop loss there are going to be times it’ll trigger and the position will skyrocket immediately after your funds exit. The cost of playing defense is giving up some offense.
  4. Because a stop loss isn’t perfect, it may make sense to trigger a sale more quickly than your stop would hit. If the position doesn’t feel right and your data points to a downward spiral, don’t wait for your stop loss to hit. Get out!

 

Stop losses are particularly tricky for penny stock traders because of the volatility of these markets. You’ll want to make sure and avoid some common mistakes made by amateur investors:

  • Placing stop losses too closely.
  • Not moving stop losses during the day to gain ground.
  • Turning winning trades into losers by depending on your stop loss to make all of your sales.

 

Here are some keys by the expert at Paradigm Capital Management to effectively placing stop losses when you trade:

 

1) Find the average volatility of a position in a day’s trading. Place a stop loss near the bottom limit of an average day’s swing immediately after making your trade. Any movement beyond that parameter shouldn’t involve your money. In some cases, you’ll see how much money you’ll be left with after the stock would sell at your stop-loss point and realize you can’t endure that much loss. Fight the urge to place your stop loss closer. People get burned because they place a stop loss directly against their initial trade to avoid losing any money. Because penny stocks breathe in large swinging motions, you’ll never make any money by placing your stop directly below your trade. Your stop loss will trigger quickly and the shares will move up right after hitting your stop loss.

If for some reason you can’t survive with the capital you’d have left after the appropriate stop loss would trigger, find a stock with less volatility that you can afford to buy while placing effective defensive measures. Maybe you’ll need to swim in the shallow end of the pool for awhile before moving to more aggressive positions.

 

2) Monitor your gains. As your positions wins ground, raise your stop loss to permanently capture profits. If the stock retraces during the trading session while you’re grabbing a cup of coffee, you’ll come out ahead of the game rather than having to start over.

 

3) Don’t turn winning trades into losers. Sometimes a stock will get volatile and you’ll have to settle for a small gain even though the stock experiences a great day. Just because your stop loss triggered doesn’t mean you have to stay out of the position! If you’re using a non-qualified account, watch out for wash sale tax rules, but besides this one tax rule there’s no reason to avoid jumping back into a winning position that had a stop loss trigger.

 

It’s true that investors love penny stocks because the huge volatility swings can create large amounts of wealth. If you aren’t careful, penny stock trading can also easily wipe out your portfolio. Not only should you take the time to do research, weed out companies with little or no product, find superior investments poised for an upswing, and invest when volume levels are beginning to increase, you should also play some smart defense to insure you can trade often enough to create the spectacular results you’re counting on.

 

If you want to learn more then you can consult with the experts at Paradigm Capital Management.

Paradigm Capital Management employs a disciplined, bottom-up approach with an emphasis on fundamental analysis and extensive management contact. The firm’s three decades of experience provide an exceptional level of insight that is reflected in their high-conviction portfolios.

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