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 you tend to make buy and sell decisions tied to fundamentals, and only buy stocks that meet very strict valuation criteria. You might then overlook some early-stage growth companies with the potential to generate significant gains. Or let's say you prefer trading the headlines—you 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, you can track your trading activity to pinpoint what has worked well and what hasn't in the past. You can either keep a written trading journal or create a spreadsheet that details your entries and exits—for example, the signals that informed those decisions, how your trades performed, and what you did right or wrong. The latter is probably the log's greatest value; you can return to these diligent assessments whenever you'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 you leveraged 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.

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

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

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

• Limit orders let you specify the highest share price you're willing to pay or the lowest at which you're willing to sell. In either case, the trade will occur only if it can be filled at your 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 you planned or purchase a hot stock for more than you believe it's worth. That said, limit orders do not guarantee the order will fill, and stop orders do not guarantee you'll get the price you set.