The Problem with Trying to Get Even on a Trade
Sometimes Taking a Loss is the Best Possible Result
Most investors tend to trade from the long side, and for good reason. Over the decades, the market has moved steadily higher. Sure, there have been declines, but the market has always (at least up to the present time) recovered all losses and moved on to new all-time highs.
Because we know that the "good-times" cannot last forever and that there will always be market corrections of varying severity, it is appropriate to share some of my trading philosophy.
I believe that the following advice is suitable for the majority of investors and traders.
- To succeed over the longer-term, losses must be minimized. It is essential to practice sound risk management so that when you do have a losing trade, the loss will never be large enough to damage your trading account. One way to accomplish that is to trade only when the possible reward is worth seeking when compared with the size of (and probability of incurring) the potential loss. The best method for managing risk is to trade an appropriate position size.
- Your trading/investing goal is to make money. You want to see your account value grow month after month. It is not a good idea to expect to make money from every trade. Sometimes the markets do not behave as expected and at other times they are too volatile for a premium-selling strategy to succeed.
- It does not matter which option strategy you decide to trade. It does not make any difference which stock or index is the focus of your investment dollar. Your job is to adopt a strategy on an underlying asset that is appropriate for your trading style and current market conditions. Do not force a trade. Remember that no specific stock ‘owes’ you a profit. If you lost money the last time you traded that stock, it does not mean that you should force a borderline trade in that same stock -- just because you want to get back to even. Initiate only suitable trades with a decent risk/reward ratio. Never adjust a position when the sole reason is that you refuse to take a loss. Never take extra risk to avoid locking in a loss.
- If you have a position that is currently losing money and if that position becomes too risky for your comfort zone, then it is time to adjust or abandon the trade. Do not increase position size in an attempt to get even. Do not hold, hoping that the stock price will reverse direction, allowing you to recover any losses.
Do not adjust the position to avoid locking in a loss (by closing the position). ONLY adjust a position when you still want to have a position in this specific stock (or index) under current conditions. Adjust the position so that the new position is worth owning -- from your perspective. That means, going forward, that both the reward potential and risk are acceptable. The money that has been lost, is lost. Don’t dwell on it.
- If you believe that one stock offers a good trading opportunity, then that’s the place to invest your money. You will be better served to get out of the risky position and move to one that you think is better. After all (to repeat), your goal is to make money for your account; and not from a specific trade.
This is a difficult concept for some people to grasp. The ‘need’ to recover losses from one specific stock -- or one single position -- blinds many to finding a different profitable opportunity. Isn't it better to earn $1,000 from a new trade than to spend an equal amount of time (and investment dollars) to successfully recover a $500 loss? The latter may make you feel good, but it would leave you with $500 less in your account.
When you find yourself struggling in the market, there are steps you can take:
- First, stop trading. Close losing positions and clear your head for a little while. It will be well worth it, both psychologically and monetarily.
- Second, regain your focus. Remember your objective. Remember your trading style and wait until your requirements for a new position are met. Finally, don’t make the recovery of recent losses your objective. Making money -- that's your goal.