How Bad Execution Killed My Trade and What I Learned

09/29/2010 12:01 am EST

Focus: STOCKS

Trading is all about managing risk and probability. The risk part is easy; you can quantify your risk by setting a stop loss target on all your trades. Yes, a stock can gap through your stop overnight, so we can’t know our risk with 100% certainty, but setting aside major overnight announcements and earnings, we can get a pretty good idea.

The probability part of the equation is a little more difficult. I don’t have empirical evidence to support the patterns I trade on both the long and short side. Others have done a decent amount of research, and I have read some of it, but at the end of the day, I have always believed that so-called “voodoo” of technical analysis is a different religion for everyone. Technical analysis, being little more than the study of the psychology of the markets, is interpreted differently by everyone, and therefore, it should not be seen quantitatively to a large extent, but as more of an art. It’s just like a psychologist, where you can go to four different guys and get four different answers to your issues. They will approach you in different ways, and ask you different questions—it’s a feel thing.

Anyway, I want to make the point in this post that you’ve got to understand and accept the risk you are putting on when you make a trade. I will review a trade of mine where I made a terrible mistake and foresake this principal, and it has cost me quite a good deal of profits over the last few weeks, especially given that my thesis was correct. It’s not enough to have good ideas; you must execute them properly.

Let’s take a look at Baidu, Inc. (BIDU) on the chart below.


Click to Enlarge

In late August, as the broader market was breaking down, BIDU was coming back down to earth after breaking out of its multi-month range between 77 and 66.50. The stock was setting up a classic pullback to breakout play, and given that this had been one of the strongest stocks in the market, the case could be made that if you were going to buy anything off the bottom in late August, it should have been BIDU. We even joked that it was a “Bi-do-or-die” market, and that turned out to be true.

And so I set up the trade. I targeted the 76.50 level as major support, thinking that the stock would bounce hard from that level. Now remember, support and resistance levels are not places where you should be buying blindly, they are placed to look for signs of buyers or sellers to come in. And sometimes they don’t.

I won’t bore you with the fundamental reasons why I wanted into this trade. This post is really about a specific technical set-up, managing risk, and executing your plan.
On August 25, at a price of 77.60, I took a long position in BIDU at half size. My plan, as I remember it, was to stop out below 74.50, which was the low from July 30, the day BIDU broke out of the multi-month range and good volume. That gave me a risk of a little over three dollars, or less than 5%—not huge by any means. And being that it was a half-sized position, the risk was pretty small.

What destroyed the execution of this trade for me were two things. First, I paid too much attention to the overall averages after I had quantified my risk in this trade nicely. Yes, it is important to pay attention to the market, but you need to stick to your plan in your individual positions once you’ve put them on, save for a complete cleaning out of risk in your portfolio due to some kind of market event.

After the stock bounced above 79, I decided to move my stop up to 76.50 because of the terrible action in the broader market. Big mistake. Without giving a position trying to find support a decent range to whip around in, you will get stopped out for pennies time and time again. Support trades within good uptrends have to be given room.

After taking my stopout on July 27 for a loss of a little more than a dollar, I never revisited the trade. That was the second mistake.

The stock went on to bounce with the market, base out above the rising 20-day moving average, and last week, it surged towards 98. Today, the stock closed around 104.
This was a trade that I set up perfectly, my thesis was correct, and the stock acted just as I thought it should. This was also a trade where my execution was extremely poor.

Learn to manage your risk and stick to your convictions in the trade.

By Leigh Drogan, independent trader, http://leighdrogen.com

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