Taking a Loss, Keeping a Stop
and Other Warm Fuzzies
Thoughts of a Learning Day Trader
By Harry R. Alexander
OK so you've heard once, you've heard it a thousand times, "You have got to keep your stops." It has been said over and over "The success of the trade is measured by your ability to keep a Stop". Every book you have read tells you to cut your losses and let your profits run. Preserve your capital. OK, so you got that rule down. You read it every day and even write it down. It's stamped on your forehead. Backwards, so you can read it in the mirror.
So as you begin trading, you paper trade for a while and get the feel of it. Some wins, a few losses, you do a good job keeping your stops.
You then move on to actual trading.
You make a few good trades and then sooner or later a trade goes against you. What do you do ? You just sit there and watch as it moves farther and farther away, finally you can't take anymore and take a 2 point loss. You feel like crap. Then of course, it turns and goes back to where you entered the trade. Now you feel all warm and fuzzy don't you !
So what's the problem ? You have read and heard over and over about keeping the stops but you failed to do so. You must be a real jerk. You have no business doing this with your money.
I of course am describing myself in the above scenario as much as anyone else. Been there, done that, got the T-shirt.
The primary problem of course, is that now that you are doing it for real, the emotional side, the ego steps in, you did not have to deal with this ugly creature when you were paper trading, now you do. There is no escape! The ego monkey is on your back ! So how do you get it off ? We'll talk about that later.
To start, I believe that what is essential to keeping the stop, is the ability to take a loss without the emotional baggage. For by definition, if you have been stopped out, you must take a loss. Nobody likes to do that.
And taking a loss day trading, is much more difficult than taking a loss as an investor. Primarily because you must act immediately. As an investor, you can cry in your beer at night. An investor can average down, assuming the stock is fundamentally sound. The investor should be dollar cost averaging anyway. At worst, the investor still has his job, As a day trader you simply do not have the luxury. That is, if you wish to remain a day trader.
In order to function and ultimately profit as a day trader you must not be afraid to take a loss. It is what allows you to enter a trade, and it allows you to preserve your capital.
Also, the cost of a loss and not keeping a stop, often lies more in the opportunity lost, than in the loss itself. Watching a trade go against you and not acting, or taking a loss that disables you mentally, will prevent you from acting on the next opportunity. I have had a trade for a 2 point loss. Standard stuff, afraid of being wrong, froze, kept saying it will come back. However, my most costly loss from a trade was -5/8. Let me explain with the following experience.
A typical morning of trading, I prepared a plan that was fairly simple: A list of open short candidates, short one of them, cover, then pick up CMGI (one of my two bread and butter stocks) on the dip and ride it. So one of my open shorts gaps up, decent volume and I short it at the open. Well it runs from the open, it starts to fall some, gets within 3/8 of my entry but then turns fast and goes up again, I cover at -5/8. RATS ! I was frustrated and angry, even though I executed a fairly decent trade (according to the rules, as open shorts may run a bit but come back 95% of the time). Feeling the way I did, I walked away. The absolute right thing to do. A couple of hours later I check in. CMGI was running hard as it often does, ran 7 points from the 10:00 A.M. dip. Closed up 8-9 points on the day.
So on a day, where I lost $600, I could have made $5000, (assuming I missed CMGI bottom and top). So with some dispassionate analysis, what was my biggest loss ?
I do not see this as a matter of hind sight saying that I did the wrong thing at the time, for I still believe that I did the right thing by taking a walk. Rather, I view it as a realization, that getting a handle on the mental aspects of trading would allow me to not be afraid of taking a loss. This allows me to keep a better stop. The better stop in turn, allows me to continue to function as a trader, and not miss the next opportunity.
So the challenge then is, how to take a loss and not get emotionally wrapped up in it, so that you:
1. Are able to keep your stop.
2. Can continue to function as a trader.
Well there is no easy answer. Part comes from time and experience. Part comes from the realization that a small loss is not the end of the world. Part comes from understanding that you are not the first one to experience the problem.
First off, you must realize that no-one likes to admit, even to themselves that they were wrong about something. This egocentric trait of all humans is the first barrier to taking a loss and keeping a stop. Well guess what? Even the best traders are wrong. Sometimes wrong a lot. Their skill is derived from admitting it quickly and moving on. So face it, you are going to be wrong. You may even be wrong a lot. Simple math says that if you keep a tight stop, you can be wrong more often than not, and still make money. Of course you'll want to be right more often than wrong, which is possible, but another subject.
There are also mental and physical aspects of taking a loss, that by understanding what they are, can help you learn to take a loss without the baggage. First the baggage...
When you take a loss, feelings of anxiety, depression, inadequacy are normal. You may have a sense of general malaise. Physically, you may be short of breath, have tightness in your chest, a head ache or an upset stomach. Probably all of the above, at the same time ! Generally it sucks.
These are normal reactions. Just being aware of them, and recognizing them as a common occurrence will soon allow them become less intense. They will occasionally not even occur. Recognizing the feelings will also keep you from forcing a trade, when you should be sitting out.
Another more elusive, but more important aspect is being on auto-pilot, in the zone. Like Michael Jordan, not thinking, reacting to the circumstances. If you ask him, Michael is often surprised by looking at replays of himself. When reviewing a replay with Bob Pompiani one time, Michael commented "I did that ? Wow! That was pretty good!" From a thinking point of view, Michael was simply not there at the time. He moved on from scoring the basket, just as he would have from missing one.
Visualization is an excellent tool. Jack Nicklaus, was playing the US Open at Pebble Beach, he was preparing for a shot, and a jet flew by and interrupted his routine. He stepped away was overheard to say "Darn, that was a good one." When asked later about what he was talking about, he said that he had rehearsed the shot in his mind and it landed right where he wanted it to.
Performance in all endeavors that demand a high level of performance can be improved by the use of visualization. Day trading is such an endeavor. It is intense, demands split second decisions while you have a high level of adrenaline in your blood. The best traders often are in a zone when trading.
So you need rehearse in your mind a trade. What are the conditions that you are going to enter and exit. Play it going with you. Play it going against you.
Try and visualize the following scenario:
You have developed your trade plan for the day, the first priority is a dumper. Imagine your self in-front of the monitor with the quote and order screens. The market has opened.
Read this as fast as you can.
OK ready... GO !
WXYZ is selling hard......YELLOW ALERT !, WXYZ SHOULD BE BOTTOMING HERE! , You prepare to make the trade, it pauses, mixed sells and buys, then all buys an the bid up-ticks, you see on level 2, the ask going, it's gonna up-tick, you buy at the ask and then another up-tick. The buys continue a few seconds, then another pause, it starts to sell, BAM! a down tick in the ask, selling, now selling at bid, the bid down ticks, 1/8 below your entry. You sell, loss of 3/16. S@#%!!!,, The stock continues to drop. Now down another point still selling. Another point down. (You feel a lot better about that -3/16 don't you ?) Another pause and buying starts, you jump in, second bottom, an up-tick, the stock runs 2 points, pauses, you exit with a market sell, the second trade your + 1 3/4.
Phew!
So how do you feel ? Do you think in real life, you would feel bad about the loss, or would you remember the winning trade ? As you review your performance, how do you evaluate keeping the stop ? Do the bad feelings of taking the loss exist ? Did they exist when you were stopped out ? If so, did they pass when it was 2 points below your original entry ? How does it feel to do the right thing ? Tomorrow, will you remember the symbol of the stock you traded ?
For the visualization exercise, you will want to fill in as much detail as possible. This includes the visual aspects of your surroundings, the motion of moving the mouse on the screen or the feel of the keyboard on your fingers. The more detailed the rehearsal, the more effective it will ultimately be. For those using RealTick, or CyberTrader, you will want to fill in more details of the trade, your order routing especially.
There are no easy answers and no quick fixes, but the above has helped me tremendously. I do not fear taking a loss as much as I once did. This in turn has helped me keep better stops and allowed me to keep trading after a loss and be profitable. The 7 point run on CMGI is still out there (look at a chart). I'm not gonna let a piddly 1/8 or 5/8 for that matter get in the way again.
One thing, let me be perfectly clear, when you have taken a loss and feel the way I have described previously, you are dysfunctional for trading (and probably anything else for that matter). You are out of the zone. When you have exited the trade, walk away. Learn to deal with the baggage later, you can not trade now.
The purpose here is to help you recognize the feelings as normal. Recognizing them is the first step towards dealing with them in a way that will let you continue to trade, and improve your ability to keep a stop, but it does not happen overnight, and even if you get by it most of the time, it is likely to return once in a while. When it does, walk.
I hope this is helpful and good luck the all traders.
Credit where due:
Golf, The Mind Game - forget the author, sorry
Momentum Investing - Ken Wolff
The Tao of Trading - Robert Koppel
General background on visualization and sports performance - Dr. Bob Rotella |
