Section 11: A Final Word

Up until now, there hasn’t been a word mentioned about trading discipline, minimizing your losses, and controlling your emotions. Yet this is probably one of the most important subjects that you must master. Even the best traders have their losing moments, and it is best that you learn a few critical lessons early in the game.

Emotions

Vast manuscripts have been written on the subject of trading with emotion, i.e., that you shouldn’t have any. Many will agree that the number one enemy to successful trading is one’s self. Such forces as greed, fear, hope, and outright foolishness can overtake your better judgment and destroy an otherwise profitable day.

However, I take a somewhat unique stance on this subject. For starters, I believe that if you are human, it is nearly impossible to control all emotion. To this day, if a trade goes very well, I get excited. If my stock tanks, I get depressed or annoyed. Such emotions are inseparable from the trading experience. So what is one to do?

The answer is to learn how to apply the proper emotion to the occasion, use them to your advantage.

Fear and Hope

One of the most unusual things about humanoids, when it comes to financial matters, is that the emotions of “fear” and “hope” are applied in reverse. The natural (but incorrect) instinct is to hope when you should really fear, and to fear when you should hope.

Here is an all-too-common example. An amateur trader buys XYZ at $10 a share, naturally feeling very certain about its inevitable advance. The stock promptly tumbles to a –3% loss. The trader hangs on, of course, because there is still “hope” at a mere 3 percent decline. But rather than rebound, XYZ falls lower. The trader is now behind 5%.

The proper thing to do, of course, would be to call it quits and take the loss. But instead, the trader hangs on, thinking it will recover. He has “hope,” and in fact, from this point forward, he holds on to the stock, getting up each day and thinking that there is hope, that today is the day that XYZ will find support and rally. The stock declines even further. Sooner or later, the losses are beyond recovery, all because hope sprang eternal.

Now let’s take the opposite scenario, where XYZ produced a rapid gain. At first, the trader is delighted at the sight of quick gain, but then he begins to think that the stock may have peaked out, and perhaps it won’t go any higher. In this case, “fear” sets in, fear of losing that nice gain. Soon thereafter, this fear prompts him to take the gains, lest they deteriorate. Shortly thereafter, the stock skyrockets for a +28% gain, with the trader, of course, having bailed out 25 percent ago.

What do these typical scenarios tell you? Hope was applied to a situation that required fear, while fear was applied to a situation that should have been hopeful. As a result, the losses were deeper than they had to be, and the winner was far less than the trader ought to have had. Fear and hope were applied in reverse.

Although it is somewhat counterintuitive, here is the proper way to apply fear and hope to each circumstance. In the case of the loser, once the trade headed south, there should have been so much fear of worsening losses that the position should have been cut loose for a minor loss. Instead, hope was (incorrectly) applied, and the losses deepened and deepened. For the winner, fear (of losses) set in, whereas the trader should have let the stock run, hoping for better gains. Instead of hope, fear was applied. You can see how this is completely backwards, and it is the number one nemesis of the trader (and of humans).

It requires some self-discipline, but that is the very first thing you need to learn---applying the proper emotion to the situation to preserve your account and to accumulate gains.

Cardinal Sins

There are nearly an infinite number of mistakes you can make as a trader, and there isn’t enough room in this book to list them all. Fortunately, however, most mistakes are recoverable---except for a small handful of some really big ones. I call these the Trader Cardinal Sins, because they will inevitably doom your account to ruin. They are as follows.

Failure to cut losses. For some reason, this is the hardest lesson for people to learn, but it is imperative that you exit a trade that is not going well. Take the loss early, never wait until it is too late. Never hang on and hope. To do so will invite Mr. Murphy, and your stock will sink lower and lower to a crippling loss. You will also find that if you don’t cut your losses quickly, it will become harder and harder to so do, and you will find yourself uttering the famous last words, “But I can’t sell now!”

One thing you have to understand is why you need to cut losses at a predetermined level. It has nothing to do with whether or not the stock will rebound. Sometimes they do rebound, but that is beside the point. You cut losses because your winners will be too small to overcome your losers, it is a matter of arithmetic. Let’s say that you usually win about half of your trades (which is typical for beginning traders). Let’s also say that your average winner is about 5%. If so, then you can’t let can’t let trades lose more than 5%, otherwise you can’t possibly win. So if you cut your losers at –5%, even if the stock takes off from there, so what---you could not let it run any deeper, at least not if you want to trade another day.

How much loss is too much? That depends somewhat on your time horizon and your average win rate. But as a rule of thumb, a loss is “too large” when it gets into the high, single digit percentages for stock, or the high double digits for options. I like to cut stock trades at a 2% to 3% loss, and options at a 15% to 25% loss.

Averaging down. The term averaging down is a method where you buy more shares if your stock moves lower, most likely a method invented by a misguided financial advisor. The “theory” is that the average cost of your shares is smaller each time you buy more on the way down, but my name for this system is financial suicide. The proper thing to do if your stock takes a tumble is to just get out and take the hit. To buy more and more as it declines is not only foolish, it creates deeper and deeper exposure to losses (because you now have a larger position), and more often than not, it will destroy you.

I can honestly say that every one of my worst losses in trading were falling for the sucker game of “averaging down.” Don’t do it---ever!

Inconsistent allocations. By this is meant trading, say, $1,000 on one trade, then $5,000 on another, then $2,000 on the next one, etc. This will lead to a dwindling bankroll almost every time, because you can’t ever second-guess what your trade will do. Consistent allocations is the only way to make steady gains.

By allocations is meant a percentage of your trading power. The amount that you allocate depends on number of factors such as your tolerance for risk, whether or not you play options, and the size of your account. But this allocation percentage is not as important as the consistency in which you implement it, so long as the amount is sufficient to overcome broker commissions on winning trades.

Traders who greatly vary their allocations almost never succeed. The typical scenario goes as follows. The first trade is for $2,000, but it heads south, and the position is closed for a 2% loss. The trader, now having cold feet, trades only half that amount, or $1,000. The trade executes perfectly for a cool +5%. Regaining confidence, he “loads up” on the next one for $5,000. The trade fails for a rapid 1% hit.

Now, take a closer look at what just happened. The 5% winner was more than enough to overcome the two losers of –2% and –1%, yet this trader is now way in the hole, due to the inconsistency of the trades. Had equal allocations been traded, his portfolio would now be about 2% above water.

The Hardest Trade

Sometimes the market is simply not tradable. Usually, this is when stocks seem to just meander around with poor volume, or the market seems directionless. In fact, strong movement, even to the downside, is quite tradable, even if it means buying put options or selling short. But when the market seems to be indecisive, without clear conviction in either direction, it is almost impossible to find anything worthwhile to trade.

Indeed, this is the most difficult trade you will ever make---none at all. Most people (myself included) look forward to trading, and the idea of sidelining all day long is not one that I ever have in mind. But years of learning the hard way taught me that sometimes it is best to just stay out.

To do otherwise is the fourth cardinal sin---forcing a trade. If you can’t find anything, then chances are there isn’t anything worth trading. Walk away, or perhaps check it out later in the day, but it is best to wait for better conditions.