All It Takes Is One Bad Trade

06/04/2010 12:01 am EST

Focus: STRATEGIES

I received an e-mail from a reader asking for advice on a position that got away from him, and he was commenting on how overall, he was trading very well, but this one stock set him back several weeks. One of the first thoughts that came to my mind is how important it is to be consistent as a trader. All it takes is one blowup to damage a trading account, reverse several good trades, or even ruin a trader’s year. This is a lesson every trader must learn, and even experienced traders can fall prey to holding onto a stock or an idea against their better judgment.

All of us, at one time or another, have fallen in love with a stock or idea and held it despite the tape telling you in black and white that you were wrong. Trading requires the discipline to adhere to a set of trading rules 100% of the time, because the bottom line is that markets are not always rational and every trader is and will be wrong a healthy percentage of the time. It reminds me of a quote from Jesse Livermore, and I'm paraphrasing here: "Getting mad at the markets for being irrational or for disagreeing with you was like getting mad at your lungs for catching pneumonia." You will be wrong in this game and it doesn't matter how good you get as a trader, there will always be times when the markets don't make sense and don't agree with you. The characteristic that separates the good traders from the failed traders is the ability to minimize the damage when they are wrong and to maximize the reward when they are right.

One way that being consistent in following rules helps a trader is that it allows them to conserve their mental capital in addition to their monetary capital. The trader who minimizes damage from a move against them is in a much better position to weather the storm when they hit a cold streak, both mentally and fiscally. Also, many people don't mention this, but it is a simple fact of life that traders (especially holding overnight) will be hit with a surprise move against them every so often. The trader who minimizes their risk consistently is in a much better place to absorb these unavoidable setbacks, and because they have conserved mental capital by not having to agonize through a pullback below their risk threshold, they are often invested long enough for a positive surprise that evens out the setbacks.

While not all traders use stops, all traders should have an exit plan and a level where they acknowledge that the market does not agree with their thesis. While some fundamental traders have a very good idea of why their are buying a stock, and therefore don't use a stop based on their strategy, the simple fact is that the vast majority of traders should be employing some sort of stop loss. Even more important than having an exit plan is the consistency of following it every time.

The current market environment remains unhealthy, and traders need to be cautious. There are several stocks that have been market leaders that have begun to falter. These are the stocks that often lure a trader into thinking they are getting a bargain, only to slowly continue to correct with the markets. Often a trader will even double up (or worse) as it corrects. The best advice I can give, and the advice I gave this trader, is to draw a line in the sand and refuse the make the hole any deeper. There are plenty of stocks out there, and the only way to trade them is to survive with some trading capital. All it takes is one bad trade to undo several good trades, or even worse, exacerbate a losing streak into a full-blown blowup. If this issue hits home with you, follow the same advice and don't continue to dig a hole for yourself. No one knows if this market is headed lower from here or not, and the most important thing for a trader is to protect their bankroll.

By Joey Fundora, trader and blogger, Downtowntrader.blogspot.com

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