by Daniel Putnam | January 25, 2013 9:35 am
Trading stocks is the kind of challenge that few people not in the trenches every day truly understand. For all that’s been written on the subject, there’s truly only one way to make money — be right — while the list of ways to lose money is endless.
Many of the common mistakes have been covered ad nauseum in countless books and articles. Among the most notable errors you’ll read about are the failure to use stops and not letting winners run.
While these two rules are the most commonly cited in articles on the subject, there also is another set of lesser-known but equally important rules that I’ve developed in years spent trading stocks and options. Used over time, these rules can help prevent unnecessary losses:
Averaging down — or adding to a losing position to reduce your average cost — is one of the most destructive actions a trader can take. For one, it works in direct violation of the first rule of trading: cutting your losses quickly. But even more important are two aspects that underlie the psychology of averaging down.
First is that the strategy probably works about 25% of the time — just enough to provide a trader with memories such as, “What about that time I doubled down on Cisco Systems (NASDAQ:CSCO) and it came back, and I got out of the position even?” Unfortunately, it also fails 75% of the time — creating trading black holes that can lead to serious wealth destruction and far outweigh the benefits of the times when it worked.
Second is the temptation of reducing your average cost on a losing trade. If you’re in a bad trade with an average cost of, say, $20 with the stock at $18.80, that $1.20 might seem impossible to make up. By simply doubling down, you can bring your cost all the way down to $19.40 and cut the gap to 60 cents. That’s a shortfall that seems much easier to overcome, and it helps ease the psychological pain of the bad trade. More often than not though, it leaves the trader in an even bigger hole than before.
This is the corollary to the first rule. One of the biggest mistakes made by individuals who trade — even those who have been doing it for some time — is to view the breakeven point as a critical level. If you have been losing money on a trade, the urge to see the red +/- dollar figure on your screen turn to green can (and will) cloud your thinking.
By the same token, you might let a trade languish when it comes back to within, say, 5% your breakeven point, as you hang around in a bad position waiting for the trade to go positive.
Worse still is watching the +/- column to determine when you have made “enough” money on a trade. Happy you’ve made $1,000, so you sell? That’s great … but more often than not, you would have been +$1,500 if you had closed the trade a half-hour later.
While common, this is a mindless way to approach trading. Over time it will lead to bad habits that inevitably will cost you money. Look at the trade based on its own merits, not where you got in. After all, the market doesn’t know the level of your trade. If holding on is the right thing to do, hold on. And if closing out the position is the right thing to do, do it.
The best way to avoid this common pitfall? Don’t even keep the window open that shows your +/- on a trade. If you do, it is a virtual guarantee that this is where your eyes will gravitate when you look at your screen. And bad decisions will follow close behind.
Just because you thought of a great idea — or worse, heard about one on TV — doesn’t mean it’s going to work right now.
Looking back, some of my worst trades occurred when I thought of an idea, became too excited about it, and put it to work right away. This is almost always a sign that greed has replaced critical thinking.
It’s better to miss a trade due to slowness now and again rather than taking hits through undisciplined entry points.
While traders have equal opportunity to go long or short, that doesn’t mean the two trades should be evaluated the same way. Crestmont Research has calculated that from 1950 through 2012, the S&P 500 rose on 53.6% of the calendar days while falling in just 46.4%. Even during 2008 and the bear market period from 1966 through 1982, stocks had slightly more up days than down days.
This means a short trade, by its very nature, has the odds against it right from the start. Bets against the market or individual stocks therefore need to be made on only the most selective basis. If you go back through your trade records and see half or more of the trades were shorts or put purchases, that might demonstrate a naturally pessimistic streak that is likely to prove destructive over time.
The antidote is to create a much higher hurdle for what constitutes an acceptable short trade. Buying when a stock is blown out to the downside is much more likely to pay off than trying to call the top in one that’s taking off. Which bring us to the next rule …
If you’re reading this, you probably enjoy trading. It’s fun, it’s challenging, and it can make money. In reality, however, it should be saved for special occasions. Fewer trades means a higher bar for the trades you do make, and you’ll be more likely to make money.
In a perfect world, the best approach to trading would be to wait for the one or two times a year when the market drops sharply over a period of a few weeks, then go long aggressively to capitalize on the rebound. Ride the rally as far as it will go with rising stops, then move back to cash when the stop is triggered and wait for the next opportunity.
Over time, this approach of making a small number of high-impact trades would — for the all but the very best traders — prove much more profitable than a high-frequency approach.
For many of us, unfortunately, that’s easier said than done.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
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