Tag Archives | losing trade

Doesn’t making money mean it was a good trade?

Some days it's difficult to find a blog topic.  When that happens I spend some time reading other blogs, looking for ideas.  One, by the Stock Bandit, Jeff White, drew my immediate attention.  I've been saying the same thing for a long time, and it's always reassuring to see someone else with the same opinion.

In a post titled: Succeed by Not Failing, Jeff offers his opinion on a topic that many consider to be controversial:

"Too many traders think a winning trade is a good trade, and a losing trade is a bad trade…a failure.  I disagree."

The result of a trade is either a profit or a loss, but not a success or a failure.  Good trades can end up being losses, and poor trades can sometimes result in a profit. 

John gives an example and provides three common ways that traders fail.  It's worth reading.

***

If this is a topic that has not bothered you, consider the situation of someone learning to trade.  He/she dutifully opens a paper-trading account, chooses a strategy, but is not confident when choosing which options to trade. 

  • The covered call writer may be torn between selling ITM, ATM, or OTM options.  Then there's the problem of which expiration month to choose
  • The  butterfly trader may not know how far from the center strike to place the wings
  • The iron condor trader is told to find a comfort zone and begin from there

Comfort zone.  That sounds good.  We can tell when a position makes us nervous or whether we are entering into a trade with more confidence than usual.  But how do we do that?  It's based on experience.  We know what works and what doesn't work for us.  It's far better to have written trade records than to rely on what may be a faulty (biased) memory, but we have a feel for what to trade.

What is our beginner to do?  When initiating an iron condor position, the beginner has no idea what makes him/her comfortable.  With no experience, how far OTM is 'safe'?  Or how much premium does he/she have to collect?  Certainly there's no clue about an appropriate position size, and trading 1-lots is often the default choice.  But there's no 'comfort' there.  It's all uncertain territory.

The Winning Trade

 If this new trader is going to learn from making practice trades, There must be an understanding of how the trade was handled. 

Let's say our trader opens an iron condor position and the market moves.  The short put option goes well into the money and even the long put is ITM.  Doing nothing – out of fear and inexperience, our trader sees the market reverse, the iron condor expires worthless and here is a winning trade.  Not only a winner, but a maximum winner.

If the conclusion is drawn that this trade 'fits' into the trader's comfort zone and that the best way to handle iron condor trades is to wait for expiry, then this trader is already in trouble. 

This is a simple example of why it takes many trades before viable conclusions can be reached and why the result does not describe whether the trade was 'good.'

On the other hand, if the trader had felt queasy when the underlying declined and covered the entire position when the puts were 2% OTM (later than many would cover), he/she would have a losing trade and may conclude that this was a bad trade and that it was handled poorly.  Especially if the trader pays attention to what would have happened (I suggest not doing that).

In reality, it was the same trade and cannot be good part of the time and a poor choice at others.  Either it was suitable for this trader, done in the right size, had a reasonable risk/reward ratio – or it wasn't.  In this extreme example, it's risk management that made all the difference.  And to make matters worse as a learning example, it was poor risk management that led to the profitable trade.

Thus, profit or loss is not the deciding factor.  It's not to be ignored, but there are other things to consider.

Please use judgment when evaluating your initial positions.  Do not allow the final monetary result to enter into the decision-making process. Take your time.  Collect data and learn to read your own body.  Discover trades that make you comfortable and those which don't. Most traders sense when there is too much risk.  That could mean 'too likely to lose money' or 'too much money can be lost.'

That trader must also try to judge how well risk was managed because that's going to be an important factor in the trader's future profitability.  When first beginning to use options in a virtual account, it pays to take notes and try to gain something from every experience.  In reality, it's not easy to understand just what was done correctly (with the odds of success on your side) and where luck (good or bad) played a role.  However, the trader does accumulate knowledge as time passes. As he/she understand the trades better, the opportunity to ask questions accelerates the learning process.

Bottom line:  There's data to collect, experience to gain, and time before a new trader can know him/herself well enough to place money at risk.

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When to Exit a Losing Trade

It's not easy to find topics for discussion, and often look at older posts for ideas.  Some of those posts are among my favorites and provide topics not disussed since their original publication.

Options for Rookies readership is constantly growing (thank you), and it makes sense to take a second look at some older posts and make appropriate updates.  Here's one (September 2008) where Jim is concerned with understanding when it's a good time to exit a losing trade.

 

Mark,

I trade iron condors and I'm stuck on figuring out when to close a losing position. It seems that closing too early is not good and neither is closing too late. Is that something that needs to be determined by back testing? Thanks,
Jim

***

Hi Jim,

I agree that exiting seems to be a much more difficult decision entering into a trade. Let's take a look at why traders feel that way.

When you make a new trade, you are optimistic.  Assuming your trades are not made randomly, there was a good reason for opening the new position, and thus, you anticipate earning a profit.  You look forward to watching this trade as time passes – until it's time to exit.  This is true if you bought options and expect to see the stock (or market) move in your direction, or if you sold options and want time to go by with no major moves.

When the trade is not working, and the position is losing money, emotional issues may make it difficult for the trader to make good decisions. 

It's all about making as many good decisions as possible.  Traders make decisions every day: Enter a new trade?  Hold the position? Adjust the position?  Exit the trade?  Every decision cannot be a money-maker, but if you can get emotions out of the decision-making process, there's a far better chance that the decision will be a good one. 

I deduce from your question that fear is your big problem.  You fear exiting too early and taking a loss when the trade would have become a winner.  You fear holding becasue losses may grow too large.  I understand.  It's a natural feeling.

But traders cannot allow 'natural feelings' to take over.  Logic and intelligence are needed.

Instead of thinking 'is this too soon,' I suggest you concentrate on only one factor:  Do you want to own this position at its current price ?  If the answer is 'yes,' if the risk and reward are still looking good to your logical (not emotional) mind, then there is no reason to exit. If the decision is based on the fact that you refuse to take a loss or are unwilling to believe that this trade has not worked, or are afraid it is the wrong decision, those are emotional, illogical decisions. That thinking will not lead to making progress as a trader.  If you truly want to own the position as it is, then own it.  

If the answer is 'no,' then there are two choices. [Do not think about what may happen in the future and please do not think about making a decision that does not turn out to win this time.  Your goal is to make good decisions, defined as working most of the time and resulting in a growng account balance]:

  • Make an adjustment if you can accomplish two things.  First, reduce risk.  Second, be certain that the adjusted position is one that you truly want to own, right now, at its current price and with its currend risk and reward.
  • Exit.

 

Trade Plan

If you make a trade plan soon after opening the trade, you will know (or at least have a reasonable idea) in advance, when you believe exiting makes sense.  That exit price may change as time passes, and you can revise the plan weekly.  But having that plan in place will make it much easier for you to know what your calm (before the loss occurred) self thought was a good idea.  That's much better than deciding in the heat of the moment  when money is being lost and you become afraid to act.

When the trade is losing money, the successful trader knows what to do.  It's true that his/her past experience plays a large role in helping with the decision.  Rookies don't have that past experience, so they must look at positions with a clear mind and try to ignore the fact that exiting the trade locks in a loss.  Having a plan helps.


Backtesting

I do not believe that back-testing will help with your scenario.  Think about it.  You must find dozens of examples of your trade type.  Then you must find situations that are very near what happened to you when you closed the trade (early) or held and closed later.  Not only must you see which move would have worked better, but you must have similar market conditions.

That means market volatility must be similar or else the comparisons are not really very valuable.  You want to find that your stock (or index) was trading with a very similar implied volatility – and that IV was trending in the same general direction (higher or lower) as when you made your decision.

P/L depends on how far the underlying moves and on the option prices.  I don't see how you can find comparable trades.  Let me rephrase that:  I have no idea how to do that.  If you do, then it is possible to back-test.

However, the bottom line stands:  If you don't want to own the position, would you continue to hold if a back-test demonstrated that it would have been profitable to hold?  As someone who does not do back-testing, I may be overlooking something in this reply. 


My philosophy

Accepting the fact that I cannot predict the future, and believing that trading iron condors is a long-term winning strategy, I am willing to take necessary losses along the way.  I make the best decision I can at the time the decision must be made.  Thus, when I find that the immediate risk involved with holding a position violates my comfort zone and makes me uneasy, I do something.  I put on my risk manager's hat and ignore the pleas from my trader pesona who wants to hold just a bit longer.

 Sometimes I act before that point of discomfort is reached, but I almost never (I wish it were never) hold out just a bit longer hoping things will change.  It's very temping to gamble by holding longer.  It's very tempting to attempt to recover losses. 

If you believe that you can make money trading, it should not be difficult to take those losses – at the appropriate time.  If you are uncomfortable with the trade it is never too soon to exit.  I believe you are deciding whether it was 'too soon' by looking at the trade after closing.  That information tells you how good you were at predicting market direction.  It does not tell you whether the exit was a 'good decision.'  Again, 'good' is defined as the trade with the better outcome over the long term.  Not the result of one specific trade.

If you can bring yourself to do it, I suggest you never look at what might have been.  Make your decision and concentrate on the next trade, not the old one.

Once we decide, our emotional side wants to know whether we would have come out better had we acted differently.  Success in the option game is measured by the growth of our accounts – over the longer term.  Some attention must be paid to doing what is right – and by that I mean doing what the odds tell us to do.  If I've lost $2,000 on a position, that's in the past, and there's nothing I can do.  Holding may give me a chance to recover that $2,000 plus make an extra $2,000. But if there's an equal chance of losing another $5,000 or $6,000, I take the loss and move on.  My goal is to give myself the best chance to earn the most money – with the least risk – starting today.  And holding a poor position is a high-risk play that decreases my chances of making that money.

If you play poker – do you take a look at the card you would have drawn had you not folded?  I don't.  Once I fold, it no longer matters.  That's the same situation here.

And, here's one more reason why taking the loss is not quite as bad as it seems.  The current position is not a good one.  It's  not market neutral and is threatening to lose more money.  If you take your loss NOW, you can open a new position that suits you.  It can be market neutral, it starts at a point that does not (immediately) threaten further losses.  It gives you the best chance to make money in the future.  Don't think of getting even, think of growing the value of your account – starting right now.

I know it's not easy to take losses, but successful traders will tell you it's necessary.   Again, all the above is how I feel and why.  It's truly up to you to decide if this makes sense or if you would rather proceed differently.  NOTE:  I am not suggesting that you take a loss every time the underlying moves 2%.  I am telling you to understand the boundaries of your own comfort zone.

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Success Breeds Failure. An Unexpected Result?

One of my interests is 'psychology of trading.'  It's a fascinating topic and understanding the basics (if there is such a thing) can truly help a trader perform better.  The difficulty with that is recognizing that any of these principles applies to you.  It's so easy to dismiss studies as being unrealistic.  If not unrealistic, then at least the average trader has many reasons why the study does not apply to him/her.

We all want to make more money when trading, but many times traders inadvertently sabotage themselves by making decisions that they sense are not in their best interests.  It's not deliberate.  There's no attempt to prove to anyone that you can do it better than others. 

It's often the result of being uninformed about the myriads of data that explains why some trading decisions are less likely to be successful than others.

One simple example is the size of one's trading account.  Many rookies put together a very small stake ($2,000 or less) and begin to trade.  The chances for success are just dismal.  As yesterday's post of the risk of ruin indicates, the less money you have to trade, the greater the chances of losing your entire trading account.  It's a statistical truth.  But, it's also ignored.

***

Recently I read a very interesting research study (actually a blog post that discussed that study).  It concerned why traders alter their behavior – depending on whether the most recent trade was a winner or loser.  It would never occur to me to alter trade size, and thus risk, on anything as flimsy as that.  However, when the sample being studied includes a large number of traders and a large number of trades, patterns emerge.

The blog was by the CXO Advisory Group. Much of what follows comes from their post,  The original paper is no longer available online. .

The 6-month study (2006) covered more than 1.3 million Indian investors and 111 million transactions worth $85 billion. The details are available in the CXO post and the paper, but the interesting points to me are: 

  • Investors lost $2.3 billion
  • Investors with positive past trades – trade more often
  • Trading
    volume is 7.7% higher for traders with recent gains than for those with losses
  • The probability of increased trading volume is 1.7%
    higher for an individual with recent gains
  • The sign (+ or -) of recent outcomes explains 89%  of the variation in
    subsequent trading frequency
  • On average, profitability of current trades is almost 60% lower for
    traders with recent gains rather than losses.
  • The more successful individual investors appear
    to be those less influenced by the signs of recent trades.

Bottom line: The sign (much more than size) of recent trades influences future trading behavior
of individual investors. This influence hurts overall
profitability.

This is the typical situation that I find so interesting.  Something minor, such as a winning trade, influences some traders to make the next trade larger.  The real question is why the ensuing trade loses so much more often.

It may be the result of being anxious to trade again, resulting in a poor choice of trades.  It may be that overconfidence ruins risk management.  There's no way to discover the answer.  The takeaway from this discussion is that mindsets can be altered by seemingly minor events.  It's important to pay careful attention to your trading plan (if you have one) and make every effort to avoid allowing emotions to affect your decisions.

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