Highlights in this issue:

* The trader's favourite tool - the stop loss...
* Trailing your stop might work for you...
* The crucial "take profit" level... and more...

From the overworked laptop of Julie Brownlee

Dear Investment Academy Reader,

Never are strict money management strategies more important than in today's yo-yo market. You might think you don't "need" them - but ignore them at your peril! Trading is a fantastic way to open up your portfolio to massive gains, but equally so, you need to protect your hard-earned cash against trades that do the opposite of what you predicted.

So, in today's Investment Academy, we're going to revisit the importance of applying strict exit points to your trading - so you can take the emotion out of the decision - and more importantly - protect your capital. If you don't apply these strategies, chances are, you're not going to be a trader for very long!

Setting a stop loss

Before you start yawning - this is crucial - and you must determine this level BEFORE you even consider opening a new trade. You set a stop loss level to quantify the biggest loss you're prepared to take on a single trade. This size of this stop loss is totally up to you, but to get you started, the general consensus is 15% to 25%. And remember, when you're trading geared instruments, such as single stock futures, every cent movement out of your favour, multiplies your losses.

Say you decided to put a long trade on Woolworths. It's currently trading at 1,200c. You decide when you place your trade that a 15% stop loss suffices, which is 1,020c. If Woolworths share price falls below this level - you cut your losses and sell - no questions asked!

This is an example of how an ordinary stop loss works. You set a level and watch the share carefully. If the share breaks the stop loss level, you act immediately to prevent yourself from taking a larger loss than you were initially prepared for.

How to lock in your profits with a trailing stop loss

While a stop loss makes perfect sense, it's totally pointless if you implement a simple stop loss without some means of ensuring you take profit when it becomes available. For this reason, some traders use a trailing stop loss (but, bear in mind, this means you might be closed out your trade because of volatility and might not achieve the full potential of your trade).

How the trailing stop loss works is as the share price increases, the level of the stop loss increases too. So, going back to our Woolworths trade example, the share price has increased from 1,200c to 1,300c. That means you raise your stop loss level to 1,105c. You keep increasing the stop loss as long as the share price keeps rising.

The most important thing you should know is the stop loss level is only raised when the share increases in price. If the share drops in price, you simply leave the level unchanged. Have you noticed what's happening here?

By continually moving the stop loss level higher, you increase the price at which your discipline strategy will force you to sell.

If you're using a trading platform to trade your trades, chances are, it'll do all the trailing stop loss stuff for you!

The art of setting your take profit levels

Now you know how to get out of your losing trade by implementing your stop loss strategy. But what about taking profits? How do you know what to do when the price keeps going up. Saying that, this is a really nice problem to have and I hope you make many trades which give you this type of "problem"!

It's important that you decide on your take profit level before you enter your trade, just as you would with your stop loss level.

So, bearing in mind how geared your trade is, you need to decide what (realistic) profit you want from your trade. Don't set ridiculous goals, make it achievable and realistic, otherwise you're going to be disappointed.

But, if you can't trust yourself against being too greedy, top slicing may be up your street. What you do here is, once the trade gets to a certain level, you sell a portion out. Let's look at our Woolworths example again and let's say you're ten times geared (every movement is the underlying share price is multiplied ten times). You need the share price to hit 1,320c to make a 100% gain on the trade. If you'd bought, say ten contracts, you could sell off five of these, protecting your initial capital.

There's nothing worse than watching a once profitable position close out of the money... Now you have the strategies at hand to protect your trades and, more importantly, your moola.

That's all for this week. Have a fantastic weekend and tune in next Friday for your next trading instalment.

Happy trading!

Julie Brownlee
for The Investment Academy