How many times have you heard this simple rule of investing? More than likely, too many times to count. The challenge is removing the emotions from the trading process to allow this simple rule to be applied. We discussed proactive versus reactive investing. That is at the root of success with this simple rule. In other words, if you are proactive with a disciplined strategy towards each position you will be successful in letting your profits run and cutting your losses. Remember the three steps are having a discipline for getting in (buying), getting out (selling) and where you are going (target). Putting these into practice is the key. For example let's put this into play using technical analysis. We have a stock channeling or trading sideways. This simply means the ETF is trading in a range over a period of time. In this example we are looking for a break higher. So, the getting in part is a break out of the trading range to the upside. Getting out starts with a stop loss. This is the process of cutting your losses. In other words, if why you bought the investment is no longer true you should be heading for the exit. This too often is where investors lose their discipline and hold on to losers. They convince themselves this is a good stock, etc. The only good stock is one that's making you money in my book. Back to the example. Our stop would be when the stock retreats and breaks below the bottom of the channel. Our stop would then be placed just below the low of the channel and we would exit the trade if the stock falls below that level. This is defining your loss. When did you do it? Prior to investing, not after! There are too many emotions after you invest to be logical. You bring back into the process the reactive investing we already discussed. The other side of the getting out is the target which is the last piece. In our example we will use the height of the channel as our target. We now have a strategy for cutting our losses (stop) and letting our profits run (target).

The final step of this process is the decision we need to make when we hit our target. Let's assume everything goes according to plan and we enter the position. It moves higher and we hit our target. Now what? We have to decide based on risk management principles what course of action we will take. For simplicity here we will limit this to:

1. Sell the entire position at the target price.

2. Sell half and keep half raising our stop.

3. Keep it all and set the stop at the level we are willing to give back if the stock reverses and moves lower. This of course is decided before we buy, so we don't drag Mr. Emotion back into the equation. When we hit our target we act according to the decision we made which is sticking with our discipline strategy.

Cutting your losses and letting your profits run is nothing more than making decision about the investment prior to investing. When attempting to make all these decisions on the fly, you get yourself into trouble and make emotional decisions. Define your discipline prior to investing not after.

 This is part 5 of a daily educational series Jim will provide for the next few weeks, exclusively here on Greenfaucet.  Click here to read part 4