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Managing a Losing Trade

There is more than one way to look at every situation. My individual perception may be different from yours. Part of the time there may be room for interpretation because the ‘facts’ are soft and may be considered from different points of view. At other times, the facts are undisputed, but people have different interpretations. Here is one example.

Do you have a loss?

Let’s look at a simple situation. You invested $10,000 in the stock market. Today you can sell those positions and collect $7,000.

Question: Did you lose $3,000?

I find it quite surprising that many people believe that they did lose money while a segment of the population believes there is no loss yet.

Yes, there has been a loss

Here’s how I look at it:

    –The market values this item at $7,000.

    –If the account is with a broker, you may only borrow money based on that $7,000 valuation. Your belief that the stock in your account is worth $10,000 is imaginary.

    –If you receive a margin call (based on a loss on a different investment), your broker will show no tolerance for your argument that the account is really worth $10,000 and that it’s not fair to value it at $7,000.

    –If you want to withdraw cash from your account, your broker will not allow you to take more than $7,000 (assuming 50% margin), even though you believe they should let you take $10,000.

    –If this were a house and not stock, your bank would not give you a $10,000 mortgage based on your estimated valuation. They would base the loan on a $7,000 valuation.

Pretty much the whole world recognizes that an investment may have been worth $10,000 at one time but that $3,000 has been lost and the current value is only $7,000.

No, there is no loss (yet)

The argument in support of believing there is no loss is this:

    –If I don’t sell my asset, I cannot have a loss.

    –A loss only occurs after I exit the trade and have no chance to recover

The large group of people who accept those arguments do not recognize reality. This is important to us because it affects how we think — and thus, how we act.

Almost all traders accept the truth that managing risk is an essential part of being a successful trader. Those traders also share the opinion that it is unacceptable to incur a large loss and that it is necessary to take some defensive action when a position is losing money and has become too risky to hold. That defensive action is (more often than not) to exit the trade, take the loss, and move on to another trade when the time is right.

However, people who believe that they have no loss currently (even though they may admit to being at risk of losing money) may stubbornly refuse to take defensive action. If they believe that closing the position is the act that creates the loss then they will hold onto risky positions, hoping that the loss will disappear. The reason this is a very poor way of thinking is that they tend to hold bad positions when successful traders understand the importance of getting put of losing trades (accepting the fact that the money has already been lost) and reinvest (at the proper time) the money into a better (less risky, more chance to earn a profit) trade.

The innocent-sounding mindset that has people believing that a loss is not a loss until it becomes realized (i.e., position closed) keeps them locked into less than satisfactory positions. And that cannot be good for long-term results. Then there is this point: If the position does recover and the $3,000 loss disappears, they feel vindicated and ignore the fact that other positions would have earned double or triple that $3,000 over the same time period.

Rethink your position if you believe that a losing trade has not yet ‘lost’ money.

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Important Post for Spread Traders

At times, when being taught something new, the teacher may fail to mention something because it is so obvious. That may cause significant harm to those who require that the obvious be pointed out to them. I remember my own struggles with trigonometry until a friend presented me with an ‘aha moment’ by showing me something (long forgotten now) that made all the difference. After that moment, trig become a snap.

For the majority of new option traders, this lesson is unnecessary. For others it can turn spread trading from something mysterious into something simple and profitable.

THE KEY: A spread is an entity unto itself and the individual options that comprise the spread can be ignored.

Example 1

    If you buy a call spread, do not sell the option you own when it can be sold at a profit. There is no profit. In order for the spread to be profitable, you must sell the whole spread for more than it cost.

Example 2

When trading iron condors: (the iron condor is the sale of one call spread and one put spread on the same underlying asset when both spreads have the same expiration)

    The put spread is not sold to make money.
    The call spread is not sold to make money.

Instead, the iron condor trade is made to make money and that requires covering both the put and call spreads for less than the premium collected.

The put spread is sold as a hedge against being short the call spread. Translation: If we lose money on the call spread, we recover some of that loss by being short the put spread.

The call spread is sold as a hedge against being short the put spread. Translation: If we lose money on the put spread, we recover some of that loss by being short the call spread.

We plan to make money by covering the iron condor position (not only one half of it) for less than the original premium collected, after time has passed and the stock has behaved (traded within an acceptable range).

This may seen trivial, and it is — once it has been learned. However, we were not born knowing this and it is something worth mentioning. I have seen too many iron condor traders cover the put or call spread when it became profitable, and thereby lost the advantage of owning an iron condor position.

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