Knowing When You Are Wrong on a Trade

01/26/2010 12:01 am EST

Focus: STRATEGIES

Jared Levy

Senior Market/Derivatives Specialist, Financial Markets Education, LLC

One of the toughest things a trader can do is admit defeat and just exit a losing trade, especially when many look to that trader for advice. Another problem many of us face is not listening to what our gut is telling us. From the time I started trading, I have tried my hardest to stay in tune with myself and my money management and risk principles, and to not let positions run away from me.

From time to time, I certainly break the rules. I have never been a big risk taker, and part of the reasoning behind that is that I recognize my faults and realize that I am human and I have certainly allowed greed to sometimes control me. In hindsight, I needed to be able to control myself when my back is against the wall. I needed to be able to just stop the bleeding, take the loss, and move on.

With large positions and big risk, you may have so much on the line that you bet big with the intentions of the big win.  And when it goes against you, the loss may be too big to stomach, forcing you to hold on. So it gets worse and worse until you have to exit to salvage what is left of your account, or you leave the position untouched until it expires worthless. Either way, you are left with a fraction of your starting account value and with shattered confidence. You are also likely reluctant to continue following your investment plan for fear of a recurrence.

Having a manageable position also comes in handy when you need to hold on to a position that may be oversold and likely to recover.

Very seldom does one walk into a trade thinking how much he will lose. Why would investors do that? Seems like they would be setting themselves up for failure right from the start. But on the contrary, it may be the thing that saves your life (or at least your dollars and sense). I have been pondering these thoughts over the weekend and they were fueled by an investment property that I am buying. In my due diligence prior to entering a bid for the home, I put the investment through a stress test of sorts.

I looked at worst case scenarios like major plumbing or electrical damage, structural damage, the life expectancy and age of the systems in the building, the condo board’s management style and history, budget, taxes, the possibility of going months without rent, etc.  All these possible occurrences and data were entered into my own little regression model of sorts, and from that, I came up with an acceptable price to bid for the home given my findings.

This sounds rather complicated, and in reality, placing an options trade is much, much more simple and there are many more realistic opportunities. The regression model that you use for gauging an options trade could be something like the profit/loss and probability calculators at OptionsHouse, or other tools or group of tools that allows you to model possible situations and outcomes.

Once you have narrowed down your strategy, you must decide on how much risk you want to take. This would depend on other positions in your account, macro market sentiment, earnings, etc. Adjusting your contract size or modifying the width of your spread are both simple risk adjustment measures.

Options and Investment Properties

Trading options, in many ways, is similar to me only being committed to the property I am buying for only a year’s time and having the option to renew if I wish. For that exposure, I risk much less than the full price of the home. If things are going my way and I believe that they will continue, I may take another option on the home or just buy it outright, but having reduced risk is the name of the game.

We should trade the market the same way, but often traders do not. Options are frequently misused and losing positions that should be cut are held, typically because of the fear of being wrong and giving up some potential profit. Another problem I see frequently is the abuse of leverage, where a trader buys as many option contracts as they would shares of stock, hoping to amplify return.

The problem is that many times, leverage works both ways—you can lose money just as fast as you can make it.

Just pulling the plug on a profitable investment and locking in profit before it deteriorates should happen more often, but here is another situation many traders find themselves in today as markets have recovered. They stay in and watch a once-profitable trade to turn negative. Apple (NASDAQ: AAPL) comes to mind here.

Maybe it is the desire to earn back losses from a prior year, or maybe you think you are “on a roll.” The market does not know who you are, it doesn’t care whether you make or lose money, and it certainly does not owe you anything. Take your bits and pieces while you can and keep your risk minimal. If something seems too good to be true or you think the market needs a break, chances are that many people are thinking the same thing. Perception often becomes reality in the marketplace as all market participants are human just like you and I.

I am sorry for the rant, but the recent turmoil last week and a sense of concern for our viewers got me on my soapbox. I am sure these concepts are not foreign to many of you, but sometimes it just helps to hear them.

We really do care how you perform and I know I speak for the team when I say we want you to succeed and profit in the marketplace.

By Jared Levy of ONN.tv

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