If you’ve got a losing trade, deal with it and move on—here's a recovery process designed to get you back on track if you make any one of four big mistakes.
Let's face it. We’re living (surviving) the era of “all about me.” We post pictures of our gourmet scrambled eggs. We tweet urgent thoughts about the perfect dog groomer. Yup. Narcissism on steroids. Except in one area.
When veteran traders lose money on a trade, that self-involved bullhorn is nowhere in sight. A trader might celebrate or blame the market or the news or timing or strategy or even aliens. Whatever his analysis, it’s kept absolutely private. How is that possible in a “look at me” world?
Unlike newbies, veteran traders have a game plan. It might not be perfect. But it’s defined, it’s something they can execute decisively. A solid plan can keep an investment strategy steady over time. No threat of losses turning this trader into a preening, bellyaching goofball. What helps our humble trader look in, not out? Two things: attitude and technique, which immediately undercut “emotional trading.” Above all, our trader has a healthy relationship to the market and keeps her head.
You’re smart, but not smarter than the cumulative wisdom of a million other traders. As soon as you think you’ve discovered the secret to successful trading, you get complacent. But complacency kills.
Solution: See each losing trade as a chance to learn. What caused your loss? Was it a wrong assumption about market direction, volatility, or risk? What can you do differently in the future? Trading is a never-ending cognitive loop. See, evaluate, learn, improve.
They say revenge is a dish best served cold, but markets are always moving. So you think the market had it in for you and caused your losing trade. Your next trade will strike a blow to restore your honor.
“Vengeance” trading says you don’t care about losing more money when you’re making poor trades.
Solution: Detach yourself emotionally from each trade. It’s tough, but it’ll help you see problems more clearly and possibly fix them faster.
This is the kissing cousin of mistake two. You try to make a loss back by increasing the risk. But if you’re not using logic when adding to risk, you’re tossing strategy out the window. You’re increasing risk on gut instinct rather than strategy. And gut isn’t always right.
Solution: Devise other ways to salvage losing trades, but allocate additional capital to new trades that conform to a defined strategy.
Losing money on a trade makes you question your strategy. You think there’s a “next big idea,” since you have a string of losers after learning all you can about volatility, probability, and options. You hear traders talk about big profits with some sexy new approach. There’s nothing wrong with learning something new (see mistake one), but don’t forget everything you’ve already integrated.
Solution: Fusing new information with existing strategies can be effective and profitable.
If you've identified making one of the mistakes at the top, consider the five-step assessment process below to kick emotion to the curb and apply the balm of logic.
Say you bought a call for $1 and now it’s worth $0.05. You lost $95 plus commissions. You can only lose another $5. If you try to sell it for $0.05, you’ll pay another commission. The trade only presents an additional $5 of risk, so is it worth hanging onto? You shorted a call for $1 and now it’s worth $50? You lost $400 plus commissions. Can you afford to lose more?
If your answer is
Yes? Hang onto the trade.
No? Close the trade, take the loss like the skilled trader you are, and move on to the next trade.
You put the trade up and now it’s losing money. With the stock at its current price, and everything you know about its fundamentals, charts, whatever, do you still feel the same way about the stock?
Yes? Keep the trade and consider attempting to improve its breakeven point by selling an option against it. Sell the option that meets your criteria for credit, theta, probability of expiring out-of-the-money, (OTM), etc.
No? Exit the trade.
You were bullish and shorted an OTM put 30 days ago and it’s now in the money after the stock dropped. Would you sell that same put today?
Yes? Keep it.
No? Close the trade, take the loss, and move on. Don’t second-guess your logic when thinking about closing the trade. On the other hand, consider mitigating the loss by improving the breakeven point with offsetting delta trades.
You have a bullish trade, like a short put or long stock. Is there a call, or call spread, you can sell to take in some credit and improve the trade’s breakeven point? Is volatility relatively high?
Yes? Credits for short calls or call spreads might be a good choice if the stock's price has dropped.
No? If vol is low (or high), consider rolling the position to a different strike in a different expiration that has price and greeks closer to your original logic.
FIGURE 1: KEEP GOOD NOTES.
From your watchlist, open thinkLog and jot down whatever will be important in making a trading decision. You can access the notes from the Tools tab. Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
Write out a checklist for your trading game plan. Review it before you do any trade. The guidelines we just reviewed are a good starting point. Commit to the checklist. Use thinkLog (Figure 1) as a convenient way to take notes on a particular trade, or even create a checklist. If you follow a plan and still lose money on a trade, you have the consolation that you were guided by logic, not ego or emotion. But if you don’t follow a plan … well, let’s just say your trader gold star simply won’t come in the mail as fast. And your dog may love you less. Huge stakes.
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Thomas Preston is not a representative of TD Ameritrade, Inc. The material, views and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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