- John Lee
- July 26th, 2010
“You have to know the past to understand the present“. -Dr. Carl Sagan
We are Humans and We have Emotions
We all know about and use stops, right? They could be hard or mental, but either way, it’s your signal to get out. As emotional creatures, we go through swings of positive and negative emotions throughout the day, week, month, year, etc. Because of the involvement with money, our emotions are magnified. There’s no such thing as “getting rid of your emotions”. All we can do is control them and a great way to do so is by utilizing stops on our trades.
There’s a guy who we will call “Jack”. In his first year of trading, he took a $20,000 account up to $73,000. Then, he took the account down to $23,000 in the same year. Seem familiar to anyone? Talk about an emotional roller coaster…geez.
Imagine yourself going from Hope to Euphoria to Denial, Panic, and then CAPITULATION. Oh, you should also be very angry the whole way down. Brian Shannon at Alphatrends.net gives a great visual of how we feel during a market cycle.
Let’s say that Jack, with his now $23,000 account, read this post. How should he start?
Learn from the Past
First, we have to address what he’s been doing. The main culprits when suffering large drawdowns or ‘blowing up’ is using the wrong position sizing and/or ignoring sell signals/stops.
Fact: the larger the size you use for a stock, the more financially and emotionally involved you will be. For example, you probably wouldn’t care too much if you have 5% in XYZ stock. This wouldn’t be true if you had 100% of your portfolio in XYZ (or worse, fully margined with 200%). You’ll likely be classified as a “ticktard” and watch every single tick of that stock because every penny might translate into hundreds of dollars.
Not only that, you’ll also be so extremely biased to the side you’re on that you are highly prone to ignoring sell signals, despite the fact that they are flashing right in your face. This goes beyond marrying a stock. The market takes your mind as a prisoner and you become a pitiful slave. The worst part? Most people don’t even realize what’s happening until it’s too late. When someone falls into this, it is known as the “Death spiral”.
Another issue that I see is taking on too many positions at the same time. The risks here involve multiplied losses if you’re on the wrong side and the lack of cash to hedge/neutralize your position to protect yourself. This is pretty self-explanatory, but it’s a good idea to always have a cash balance. You never know when you’re going to need it.
A really big issue is the use of heavy margin. When you’re winning, it’s great, isn’t it? The problem is that even though you may be winning huge, you’re reinforcing a negative (potential) habit. Sure enough, one day the market is going to come and bite you hard. Then what happens? We start another emotional roller coaster. This happens so many times, doesn’t it? We may tell ourselves that we won’t do “this” or “that”, but in the end we do it anyway. This is sort of like getting blacked-out drunk throwing up everywhere on Friday night and waking up on Saturday morning telling yourself that you won’t go out again. What might happen is that your friends may call you up saying that they can get you in a club for free and get free VIP, unlimited drinks, and a good supply of scantily-clad women for the entire night. Guess what you’re going to be doing? Not staying at home reading a book…
Smart real estate investors always have cash and equity. Those RE investors that leverage themselves to the hilt get in trouble. They are then forced to sell or risk foreclosure. Even if one holding in the portfolio faces a decline in equity/cash flow, the other properties come under pressure. Why? Because YOU are under pressure. Sometimes, it’s a good idea to cut the non-performing property as soon as you can. Which brings us to this…
Losers
We’re talking more specifically about holding onto losers and adding to losers, the fastest ways to bleed your account out. In fact, I just thought about this. We can compare ‘adding to big losers’ with applying a band-aid on a self-inflicted gunshot wound — you may feel like you’re doing the best thing, but chances are, you made it worse by waiting too long. We can describe ‘holding onto losers’ simply as a way we “hope”. Hope is an emotion, and what are emotions? They are ways human beings cope with different situations. In this case, we put more emphasis on the best outcome and try to ignore the worst outcome (and many times, it’s the worst outcome that wins). That’s why we have stops, but sometimes, stops for trades aren’t enough.
Stops for Trading Accounts
What I propose is the use of stops for trading accounts. Now, I’m not talking about a margin call from your broker because you screwed up so badly that someone you don’t even know has to sell your shizzle. I’m talking about setting a personal and voluntary limit on daily, weekly, and/or monthly losses. This may seem like hard work, but it really isn’t. In fact, people shouldn’t mind considering this idea if the above scenario happened to them before.
Reality: I am ‘Jack’. Seven years ago, that is the exact thing that happened to me. I learned a while ago to let go of thoughts such as, “I wonder how further along I would be if it didn’t happen”? It doesn’t matter anymore. I learned from the past and I let it go.
I hear too many “blow up” stories. Actually, I hear them every month and it’s non-stop. There’s a simple way to prevent this problem. If you’re in this situation right now, money is a short-term issue. The concern is the paralyzing psychological damage that may result from such massive equity swings. Chances are that the traders/investors that got axed during the Financial/Credit Crisis still have not fully recovered psychologically. We still hear stories about how people lost everything during the Tech Crash and that was almost 10 YEARS AGO! People will still be talking about OUR crash for many decades to come, regardless of whether or not we are on the road to full recovery right now.
Coping in the Present
So what did I do? I set 10% monthly loss limits. I had many months of draw downs when I started, but I never broke past the 10% level. In fact, I was so scared that I would stop trading once I reached 5-7%. I just had this feeling that I would probably hit a total 10% loss if I didn’t temporarily stop. It was because of this rule that I am proud to say that I never ‘blew up’.
Fear is bad, right? Not all the time. The fear of losing badly was a good thing. If I ever got to my danger (PAIN) threshold, it would stop me cold in my tracks. After all, if I even got near that point, it meant that I wasn’t “doing it right”. Something was terribly wrong.
For those that are conservative and risk-averse, you can set weekly loss limits. A good start would be 5%. If you lose 5% in a week, it’s time to re-evaluate what you’re doing. It’s time to go back through your charts and study them as if your life depended on it. Many times, it means cutting everything out of your portfolio and starting fresh with a clean slate. I highly recommend this because you are 1) no longer biased to one side because you have no financial incentive to take a side, 2) your mind is clear and you can make rational, analysis-driven decisions.
The hard thing would be to let go. If you ever had an ex-girlfriend (or ex-boyfriend), you know how hard it is to ‘let go’, but you somehow managed to do it anyway, right? Most times, it turns out to be a great decision because you learn valuable things from your experience and carry on that wisdom with you.
If there’s one point in this entire article, I would encourage traders to set loss thresholds in your account. This will be a HARD STOP in your portfolio.
My Stop Got Hit. Now What?
STOP! You may have to clear out all of your losers, or maybe even go into 100% cash. Clear your mind. If you have a hobby, go work on it. If you love reading, read up on some trading books you may have missed out on. Do whatever you need to do to step away. Why? Because at this point, you may be emotionally charged and may be tempted to “make back your losses” (didn’t we already talk about “hope”?). We want to be centered and rational as much as possible. When you are focused and ready, you can re-establish your threshold. If your portfolio ‘stop’ gets triggered again, then you are really doing something very wrong. You may need to consult with a trading coach. A great thing about twitter/Stocktwits is that there are so many trading coaches out there. I am one myself and have trained dozens of traders. Don’t be afraid to ask for help. I didn’t have anyone to ask for help, so along the way I got my answers out of the hundreds of books I read and through trial-and-error testing. Most people would love to help other people, and that’s what I, and many others, do.
Back in the Game
Once you’re re-focused and ready (and have your head screwed on right), then you should start off small. Listen, you’re basically born again. Start off small to see if your new analysis is working. Before all of this, you should already have created a plan. Work your way up and maintain your portfolio stop. Don’t forget to start off small!
No one was “born” a good trader. That’s bull. Most of the things involved with trading go directly against normal human instinct. We develop everything we need to survive in the market.
For the Future
Consider the things I just mentioned. It may or may not help you. You may throw this post in the trash can, and that’s fine. I’m simply sharing with you what helped me seven years ago and it may help you too. If you are currently in a state of trading distress or are having major issues, feel free to shoot me an e-mail: John @ Stocktwits.com (no spaces).
Don’t forget…have patience with yourself and fight hard for what you want.
“The best thing about the future is that it comes one day at a time.” -Abraham Lincoln