Four Trading Myths—Busted: Classic Trading Adages

If you've traded long enough, you've probably heard an old trading adage being spewed from an authority on the markets or trading. While heeding sound advice is a good thing, not all advice is equal. When adages turn to myths, it's time to bust ‘em. Here's four of the biggest.

Myth No. 1—Cut Your Losses Short, and Let Your Winners Run

What it means. One of the oldest ones in the book. The idea is that your long-term trading success is determined by large winners. If you can just keep the losses on your losing trades small, the large profits from the winners will offset them, and you'll be profitable over time. You'll hear stories from investors about how they bought some high-flying stock at a much lower price, or bought some out-of-the-money calls for pennies that turned into dollars. They will likely attribute that to forgoing taking a small profit, and being patient enough to wait for the big score. You will likely not hear them utter the word “luck.”

Why it's busted. This isn't necessarily bad advice, but it doesn't tell the whole story. Every option trade, for example, starts as a loser, simply because of the bid/ask spread. And you could also get whipsawed out of every type of trade on an intraday swing, if your only criteria is to exit on “small losses” alone.

Further, trades with huge profits don't happen very often, and this rule doesn't give any guidance about when to take profits to make sure they don't turn into losers. For example, how much should you let a winning trade “run”? The longer you hold a profitable position, there is a growing likelihood that the stock could reverse itself and turn that winning trade into a scratch, or even a loser. That's why this adage seems to be more about luck than strategy.

Make it smarter. Let's flip this one on its head. Instead of focusing on trying to get big wins, you may want to consider trades with smaller profits, and with fewer, smaller, losing trades. In other words, keep both your potential profits and losses small, using strategies with inherently higher probabilities of success, and lower, defined risk. That doesn't mean you should be trying to scalp stock, and run up huge commissions. For example, option-credit spread strategies can have higher probabilities of profit, and have defined risk where the maximum loss is limited, such as vertical spreads and iron condors. They can be the foundation of building a portfolio where profits are built up slowly, over time.

Myth No. 2—Always Use Stop Orders

What it means. The “flash crash” of 2010. The financial meltdown of 2008. The collapse of the “irrational exuberance” in 2000. And the granddaddy of them all—Black Monday, 1987. These events are etched into our financial subconscious, and woe to any trader who blithely buys stocks ignorant of history. Stop orders (or stop-loss orders) are activated when the price of a stock drops to a certain level, and routes a market order to close a position to limit the loss. The objective is to keep a small or moderate loss from turning into a monster that can wipe a trader out—particularly if he or she is trading on margin.

Why it's busted. Stop orders seem to make sense, but the big question is, where to place them? A stop price that's too close to the current price can keep losses small. But a long position can be stopped out as a losing trade before the stock rallies, and the position potentially becomes profitable, simply because of the stock's random up-and-down swings. A stop that's too far away means the potential loss is much greater. Either way, a stop order doesn't do much to protect you if a stock “gaps” lower—dropping to a much lower price on the open of trading (or possibly during the day)—that results in stop orders being filled at prices much lower than the stop price. And if you're using a stop-limit order, fuggedaboudit. Your stop might get triggered, but it the stock is volatile enough, you may never get executed.

Make it smarter. Using stops is a rudimentary way to manage risk on a stock you've bought. But a smarter way to think about it is that risk management starts at order entry. The maximum loss on a stock position is the difference in the price you pay for the stock (plus commissions and fees), and $0. On a $20 stock, that's $20 max loss per share, or $2,000 for 100 shares. But you don't really know your potential loss with a stop order. Rather, use strategies where the max loss is known when you enter the order, and is within your risk parameters. For example, certain option-spread strategies have their max potential risk defined to either the debit paid, or the difference between the long-and-short strike prices, minus the credit received. A bullish spread with a maximum possible loss of, say, $60, would lose no more than $60 plus commissions and fees, even if a crash takes the price of the stock to $0. No stop needed.

Myth No. 3—Diversify Your Portfolio With Stock, Bonds, And Cash

What it means. Who knows which stock, sector or product will go up in the future? Instead of picking one, spread your investment dollars around to a variety of stock, bonds, funds, and leave some cash in reserve. This is diversification, and it can mean your portfolio won't see such large swings in profit or loss, and will hopefully benefit from the component assets rising over time.

Why it's busted. It's true you don't want to take every penny you have and buy some stock, or option, or bond, and hope it goes up. But, with an efficient market, you can't really predict which way a stock or bond will go next. Diversification doesn't change that. And traditional diversification doesn't factor in the relative risk between assets like bonds and stocks.

Make it smarter. Diversify, but diversify across time, strategy, and markets. Spreading your trades out over time, and using strategies like certain defined-risk, higher-probability option spreads, such as verticals, and those found on page 18, that let you take advantage of changing volatility and rates of time decay.

Also, if you use strategies that require smaller amounts of capital than buying stocks or bonds, you can have smaller amounts at risk across even more stocks, indices, or sectors, creating even more diversification. Consider using tools like the beta-weighting tools on the thinkorswim® trading platform to help assess possible total risk of all your positions.

Myth No. 4—Volatility Is Bad, Bad, Bad!

What it means. Stocks can move up and down, and volatility means how far they can move up and down. And with most people buying stocks, bigger moves to the downside are scary, and a reason to avoid investing in stocks during volatile times.

Why it's busted. Guess what? Volatility works both ways. A stock that has a 20% move up, is just as volatile as a stock that has a 20% move down. Those big winners some traders chase are only possible in volatile markets. Plus, volatility changes all the time. It moves up when there's a lot of fear in the market, and it moves down when there's more complacency. And complacency often sets in after a big rally. So, when you decide volatility is low enough to start investing in stocks again, volatility can spike up with a big sell off.

Make it smarter. High volatility that means larger potential moves in the stock price, also means potentially higher option premiums. And that can mean larger credits for strategies, like covered calls and certain option spreads. Those larger credits can also mean larger potential profits. Just because the credits are higher doesn't mean you wait until volatility is high to load your portfolio up with short-option strategies. Be aware that larger potential profit usually means larger potential loss as well. Keep your position size small, so that even if the worst case happens, whether volatility is high or low, the loss is manageable.