Rescue Losers with a “Lemonade Trade”

07/26/2011 3:30 pm EST

Focus: STRATEGIES

Courtney Smith

President and CIO, Courtney Smith & Company

Even the best signals sometimes fail, and Courtney Smith explains the "lemonade trade," which is designed to recoup losses from failed or failing trades and is proven over 75% effective.

My guest today is Courtney Smith. He’s a well-known speaker in the trading business and he’s mentioned something in the past called the “Lemonade Concept.” We’ve asked him to come here to explain it today. First of all, Courtney, what is the “Lemonade Concept?”

The lemonade concept is where we take a losing trade, which is lemons, and we turn it into something sweet, which is lemonade. Or maybe we can even turn that losing trade into a profitable trade.

The concept is is that we have a losing trade. We used a technique which normally would create a profit, and yet it didn’t create a profit. That means something abnormal occurred in the marketplace because your technical signal, whatever it is, failed.

Let’s say, for example, you’re using a breakout. The market breaks out above a previous high, goes up, turns around, and comes right back down. You’ve got a failed trade at that point.

There’s an old trading saying that “A failed signal is a signal” and why is because something abnormal or unusual has happened. As traders, we need to pay more attention to things that are unusual.

The way the lemonade concept works is you go back, and whatever technique you are using, see what would happen if you reversed your trade and went the other direction and held it for just one day.

For example, if you see a breakout, the market turns around, comes down, you get out of the trade, but sell short at the moment you get out of the trade. Hold it until the next day, 24 hours later, and that’s nearly always a profitable trade.

About 78% of the time, the lemonade trades are profitable using the techniques that I teach. That’s the basic concept.

And do you recommend doing this on every failed trade that you do?

Absolutely, because something unusual happened. A failed signal is a signal.

The cool thing, as I say, is the techniques that you use to enter and exit may be 50%, 55%, 45% profitable, but the lemonade trades for most things, like inside days, breakouts, those kinds of techniques, are about 78% accurate.

What that means is most of the time you’re simply reducing the size of your loss, but think of what you’re profitability is as at the end of the year if you’ve reduced the size of your losses by 50%. And sometimes we can actually turn a losing trade into a winning trade by that second trade, which I call the lemonade trade.

Traders have a tough time after they’ve taken that losing trade to jump right back in there and do that, so it’s a little tough to get right back in and go the opposite way immediately.

Correct. Well, that’s the challenge. Intellectually it’s an easy concept to understand. Hopefully I’ve explained it clearly here. But you’re right, psychologically, people don’t have the ability usually to flip from long to short or short to long in a nanosecond. That’s what this requires.

But you know what, I’ve found that most people can actually do it. It’s actually surprising to me. Psychology is very important.

I find that it’s easier for people to do this lemonade concept than it is to put in a fourth trade after they had three losing trades. That seems to be very difficult; but in this case, there seems to be almost a feeling that they want to punish the market for having won the last trade, and so there seems to be a psychological quirk that allows people to actually flip. A lot of people can flip anyway.

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