Keeping Losses Under Control

This post by Brian has been promoted from StockTock Social.

Ever have this happen? You have gone through your pre-trade checklist: Market favorable for the trade. Sector favorable for the trade. Price and volume action for the chosen security are acting in a favorable manner. Technical items are in perfect alignment. Entry point calculated and the market arrives at that price point according to plan. Your broker actually executes your trade at your limit price immediately after your finger leaves the keyboard. All stars are in alignment and you start to plan for the in depth interview that Trader Monthly will seek from you, once the trading world learns about this brilliant trade.

While conceptualizing the witty remarks that will be your talking points with Trader Monthly, you notice the one minute live chart with your newly acquired stock appears to be malfunctioning. The price is moving against you. First slowly, but then momentum appears to be accelerating. Hmm. You check the news wires and learn of no news. Nothing on the chat boards or blogs. But the price action continues against you. Hmm. What was going to be a scalp now turns into a day trade. The mental stop you had for exiting the position is now adjusted with the new time frame for the trade. But the price keeps moving against you and at the end of the day, you decide this should probably be a swing trade and don’t exit the position when it is down 8 percent from your entry. The next day you can’t believe your stock has gapped against you and now your 8 percent loss is a 15 percent loss and growing. Well, you decide, I will just hang on to get back to even and then get out.

Been there and have done that. That type of decision-making is not good for your trading capital or for your longevity as a trader. We all know to cut losses when they are small. We all know to honor our exit or stop loss points. We all know to run a balanced book and not go “all in” on any one position. But on those rare occasions when our trading “id” overcomes our rational “ego”, what are we to do with positions that have gotten out of hand? A few ideas:

1. If you have gone “all in” on a position and its price movement determines what trading capital you will have in the future, it is imperative to immediately preserve that capital from further depreciation. Cut the position in ½ and set actual stop orders for the remaining position in ¼ increments. If the position and the market finally see the light and move in harmony with your previous thoughts for the trade, you can still tell Trader Monthly about your brilliant trade, just omit the part about cutting it in ½.
2. Whether you are all in or not on any trade that has passed reasonable stop loss amounts, the worst thing to do is to freeze and watch the action. “A good retreat is better than a bad stand” is the Irish proverb. It applies to trading as well. If the position has moved passed your stop loss, Get Moving! Sell 100 shares. If it moves against you more, sell another 100 shares. Starting to cut the position is action, and is preferred to inaction.
3. Hedge. If you want to hold the position and if the position doesn’t represent an unduly large percentage of your trading capital (no more than 10 percent), then hedge the position. Protect the downside by buying puts, or generate income against the position by selling calls. If you buy an investment property, you wouldn’t think twice about getting insurance. For a longer term stock position, a put is your insurance policy. By the same token, if market prices for your investment property are not what you anticipated, you are not going to just let the property sit idle. You will rent it out to generate income. Selling calls against your stock position is “renting it out” for income.
4. Trade around the position. I usually won’t do this with shorter term trades. If I am wrong, I am wrong and cut the loss. On a longer term swing trade of weeks or months, I may trade around a position to alleviate short term pressures that are against the primary trend that I believe my trade will ride. Lets say I am short XYZ stock for reasons that will play out over several weeks. If there is short term daily buy pressure, I may buy calls or the stock to grab a piece of the action on the upside, and mitigate losses on the primary position. I do this rarely, because it devotes more capital to a single trade, and now I have to manage 2 positions rather than 1. I know other traders who are more adept at short term trading around their long term positions.
5. Letting losses get out of hand not only harms your trading capital, it also harms your trading psyche as the position continues to move against you. You begin to question your abilities and your success as a trader. Don’t let any position do this to you. There are thousands of stocks to choose from. Don’t let any one position at any one time undermine your capital or your confidence.
6. Once you have handled the position, do a post mortem of the trade. What was the trading plan going in? What went wrong? What trading rules can be used or refined to make a better trade next time? The best learning lessons are those made from our mistakes.
7. The market is open 5 days a week, but it doesn’t mean we have to participate. If I find myself not trading well, I take a break. Or reduce my position sizes. We can all get into ruts of poor trades. There is no rule that requires us to trade every day. Sometimes a day or two away from the market in a flat account can make all the difference.

These are just some ideas from someone who has had more than his share of wrong trades. Search out other ideas for managing these trades, and perhaps I will be reading your interview in an upcoming edition of Trader Monthly.