How to Recover From a Big Trading Loss

The markets can sometimes shift rapidly. And while volatility offers plenty of opportunities for big wins, it can also result in hefty losses.

Like many investors, I know firsthand how difficult it is to rebuild confidence after a particularly stinging setback. If tough market conditions in the past have left you with cold feet, consider this six-point plan to help you start trading again.

Traders need to be able to recognize their strengths and weaknesses—and plan around them. After any loss, regardless of how big or small, I always perform a post-trade analysis to understand what to do differently next time. Did I miss something in my research? Did I let my emotions drive my decisions?

Let's say a trader tends to make buy and sell decisions tied to fundamentals, and only buys stocks that meet very strict valuation criteria. They might then overlook some early-stage growth companies with the potential to generate significant gains.

Or let's say a trader prefers trading the headlines—they might grab some flashy stocks and get burned, only to see more risk-averse traders do better. In both cases, the mistake was the same—rigidly sticking to a single approach left the trader blind to some good opportunities. And in both cases the lesson is to be open to multiple methods of selecting and analyzing prospective trades.

On a related note, a trader can track their trading activity to pinpoint what has worked well and what hasn't in the past. A trader can either keep a written trading journal or create a spreadsheet that details entries and exits—for example, the signals that informed those decisions, how trades performed, and what they did right or wrong. The latter is probably the log's greatest value; a trader can return to these diligent assessments whenever they're considering similar trades or evaluating new ideas.

The silver lining of any investment loss is the ability to use it to offset capital gains (or offset ordinary income, up to $3,000 per year). Not only is it a tax-smart strategy, but also knowing that leveraging a loss to save on taxes can provide some consolation as well as boost morale. Even so, it's best to keep losses small and control the risk against major capital drawdowns—a write-off can only go so far.

A trader might be tempted to jump back in with both feet, but taking on smaller positions than one's used to is worth consideration. For example, if under normal circumstances a trader never risks more than 5% of their trading portfolio on a single trade, after a big loss a trader might reduce that to 2% or 3% until they feel they're on solid ground. This is especially true during periods of high volatility, when major market swings can shake a trader out of the market fairly quickly.

In a similar vein, instead of purchasing, say, 100 shares of a new position, a trader could slowly scale up by purchasing 20 shares to start, then adding to their position anytime the price dips. The same goes for selling a winning position: A trader could scale down by selling in 10- or 20-share increments if the stock is still climbing or if they've reached their threshold for a single position in their portfolio. In both cases, a trader would be limiting their risk—and potential regret—by trading in pieces. Setting price targets for exits in advance, even the incremental ones, can help with this strategy.

Limit and stop orders can help take some emotion out of trading and help traders stick to their exit plan. As a reminder:

• Limit orders let a trader specify the highest share price they're willing to pay or the lowest at which they're willing to sell. In either case, the trade will occur only if it can be filled at the preferred price or better.
• Stop orders execute and become market orders only when a specific price level is reached or exceeded. This does not guarantee an execution price; the trade may occur below, at, or above the stop price.

These tools can help reduce the impulse to hang on to a position for longer than planned or to purchase a hot stock for more than a trader believes it's worth. That said, limit orders do not guarantee the order will fill, and stop orders do not guarantee a trader gets the set price.