Everyone makes a bad trade now and then
Professional traders say they feel good about their performance if their success rate is anything above 50%. Imagine that success rate in other professions. What if your doctor was only right 50% of the time? What if an architect charged with building a new bridge only had a 50% success rate? Seems a little scary, doesn’t it? It is, but even with that low success rate it’s still possible to make money and the secret lies in managing your trades. You have to know when a loser is really a loser and when to let winners run.
If you’re a retail investor, it’s hard to know what to do when trades don’t work out the way you hoped. Here are a few ideas.
Just like anything else, the best way to manage a bad trade is to reduce your risk of finding yourself in that position in the first place. You’ve probably heard how you should do your research but what does that mean to a trader? Apart from Yahoo! Finance and Stock Twits, there are some basics you’ll need to have dialed in. First, it means that you should have better than average knowledge in technical analysis. You should know how to read a chart. Don’t bother looking at a chart that doesn’t have the 20,50, and 200 day simple moving averages on the chart. For shorter term traders, these are some of the best indicators of what a stock is going to do in the near future.
Avoid the Losers
Not the losing trades but the losing companies. It’s all about risk/reward. There are thousands of stocks in the market so why would anybody pick a stock that is in a downtrend when there are others that are heading higher? Value investing is different than trading. Stick with the stocks that are heavily traded and by all means, avoid penny stocks. When something is cheap in price it’s cheap in value. If it wasn’t, everybody would buy it and that would drive the price up.
Don’t Double Down
Think of your days as a child. If you ever had a lemonade stand or something similar where you set up a table in front of your house to sell something, you remember how good it felt when somebody would stop at your stand and purchase what you were selling. It was empowering but what if you lived on a street that had little or no traffic? After a day or two you would resign yourself to the fact that your location is a losing location. You would either cut your losses or find another street.
Amateur traders do the opposite. When their lemonade stand fails, they purchase another stand and put it on the same street hoping that two will be better than one. If you were a long term investor who believed strongly in the strength of the company, doubling down would be an appropriate strategy. When investors double down, that lowers their average cost as they wait for sometimes years for the stock to rebound but if you’re a short term trader, somebody who holds a stock for a month or less, this strategy often does nothing more than double your losses. When a stock takes a nosedive, it tends to take a long time to recover.
Set Your Stops
None, zero, zilch! That’s the number of trades that should sit in your account without a stop loss on it. The conventional wisdom is to never let a stock trade lose more than 7% of its value and never let an options trade lose more than 30%. If you allow a trade to get outside of those stops, you’re not practicing good trade management. Always set a stop.
How is it that a 50% success rate can still turn a profit? Because if you only lose 7% on one trade but made 30% on another, you’re still up (before taxes and commissions) 23% and that’s a substantial gain. When you limit your losses and let your winning trades run to the upside, you will make money.
It All Comes Down to This…
What do you do when a trade goes bad? First, examine the risk/reward before entering the trade and by all means, don’t overtrade. If 10 people with what they thought were great business ideas showed up and asked you for money, would you give it to them? You would research each and maybe invest in one. Be choosy with your trades. Last, there’s no room for hope in trading. Cut your losses early and fast. When you hope that a losing trade will turn a profit, you’ll often be disappointed.