us stock market, trend trading stock

When I think of my youth and the many pieces of advice I heard related to playing different sports, I often think how inappropriate they are to trading. "It ain't over until the fat lady sings." First of all, the fat lady usually sings at the beginning of the game and almost never at the end. Obviously, the expression means to keep fighting until the end. "Never, ever, give up." If we followed these sage pieces of athletic advice, we would likely doom our trading. In fact, successful traders do almost the exact opposite. Rather than waiting until the bitter end, the good trader cuts losses early. As soon as it is apparent that a trade is not going in the right direction, the successful trader exits the position. Many times, that means that a loss must be taken. Football coaches will tell us that losses are absolutely unacceptable. Good traders will tell us that losses are a fact of life and many times even a good trade can result in a loss.

I'm sure it sounds odd to hear that a good trade can result in a loss, but what I mean is that one has made a good trade if he has set a downside exit before ever entering a position and then closes the trade if that exit is hit. We must remember that on any given day there is a 50% chance that a stock will go up and a 50% chance that the stock will go down. If we have entered a position where we will profit when the stock goes up, we must recognize the possibility that we may be wrong. No matter how hard we try, there is nothing we can do to influence the movement of the stock on any given day. If it moves against us and hits our exit, the right thing to do is to get out. We have then made a good trade. However, if we say to ourselves "it'll come back" and stay in the trade, we have made a bad trade if the movement continues against us. At that point, we are only hoping things go our way. Hope may work in athletics, but it has no affect on trading. What we may hope does nothing to influence the price of a stock in my experience. When we entered a trade, we presumably had a reason to believe the stock price would move in a specific direction. When it moved in the opposite direction it told us that we and our reason were wrong. That, in my view, is the time to recognize that we made a mistake and cut our losses. Unless we make that decision at that time, how are we going to make the decision as to when we will cut our losses? The argument that "it'll come back" is spurious. It may come back and it may not. The point is it did not perform as we initially had reason to expect so we no longer have any business remaining in the trade.

In trading stock and options, score is not kept by the number of wins and losses, but rather by how much we make or lose. Those can be two very different concepts. As I pointed out last March in my article on money management, we can lose 60% of our trades and still be profitable overall if we manage our money appropriately and pay attention to reward to risk ratio. Of course, the higher our percentage of wins, the greater the likelihood that we will be profitable overall so long as we don't let our losses run. If we "wait until the fat lady sings" when trading, we set ourselves up to lose. We then have made a decision to wait until the bitter end rather than cutting our losses and moving on to another trade which could be profitable.

If you have ever played in or watched a football game, you know that emotion is an important element. In trading, the absence of emotion is the important element. Once a trader permits emotion to rule his trades, he has significantly reduced his likelihood of success. He is being governed by greed and fear. The football player, on the other hand, can enhance his likelihood of success with an emotionally charged approach to the game. How often have we heard a football announcer marvel at a player sacrificing his body on a play? Should we be marveling when we sacrifice our money on a trade? Of course not. Our first objective in trading is always to limit losses and only once we have done that can we concentrate on profit.

In sports, it is considered unsportsmanlike to run up the score. In trading, that is exactly what we do want to do. Our objective is to let our profits run. Often, the inexperienced or unsuccessful trader will cut profits short. In terms of overall success, that is as bad or almost as bad as failing to cut losses. Let's save the gallant comeback for our favorite team. Meanwhile, we can keep ourselves in the trading game by disciplining ourselves to cut losses promptly and let profits run rather than looking for the big play each time.

Good Trading!
Bill Kraft

Mr. Kraft's past articles are posted on our website for your review.

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