Locking in a loss
We all know that taking losses is necessary and we all prefer not to do that. However, one of the most costly mistakes that traders make is refusing to take a loss when
- They no longer like the position
- The trade has become too risky to hold
- The trader’s maximum loss for the trade has been reached
Consider these scenarios:
Exit or Adjust
Scenario a) A trader is managing a position that is moving against her. Let’s assume the position is a put credit spread and her underlying asset is moving lower. Not at the stage of capitulation, she makes a well-judged adjustment. Next, the underlying moves lower aggressively, and the risk is more than our trader is willing to accept. The adjustment has helped, but not enough. The position is closed. The loss is accepted as the cost of doing business and she is already looking for a good opportunity for her next trade.
Scenario b) Some months later the same trader finds herself in a similar situation, but this time she is short a 10-point call spread (sold, collecting $200) that has become too risky to hold.
She has two choices: The first is to pay $400, take the loss and eliminate all risk by closing the position.
Alternatively, she sees a decent adjustment. More than that, it looks to be a good trade. It eliminates the possibility of a large loss, although money is still at risk. This adjustment requires an outlay of $300 to execute the trade. That’s uncomfortable because that’s more cash than she received when selling the call spread.
Our trader thinks about this and decides that making the trade would be foolish because once the $300 is paid, she would own the position at a $100 debit, still have some risk, and would lose money (all options expire worthless) if the market moved lower. That could easily result in all options expiring worthless.
The position is closed (by paying $400) and the adjustment idea is discarded.
This scenario occurs in the real trading world. I’ve received several comments/questions on this topic from both readers of this blog and Gold Members at Options for Rookies Premium.
It’s a realistic mindset because traders behave just as our trader did. Whenever an adjustment costs more than the original trade credit, it is abandoned. I hope to persuade you that this is a losing mindset by making some points that I have discussed previously in this blog.
But first a clarification: The discussion below assumes that the adjustment is good and needed. It assumes that the adjustment is not made with the sole purpose of avoiding an exit that locks in a loss. This is a very important point., Many traders adjust just to stay in the position. Do not depend on good luck to protect the assets in your trading account.
1) There is nothing wrong with exiting when you are uncomfortable with a trade. Thus, the decision to exit is always acceptable
2) When you have a choice between two reasonable alternatives, to find success over the long term, it’s important to make the trade that leaves you with the better position – but there are conditions
- The final position must be one you want to own at the price paid
- If the condition above is not satisfied, then choose the exit
- The adjusted position must be within your comfort zone regarding risk and potential reward (from today into the future, not from the original trade price)
3) Why did our trader choose to buy back the original trade, paying $400 instead of making a good adjustment and paying $300? Answer: Because of a losing mindset. It is not uncommon for new traders to believe certain ‘rules’ with no idea how those rules originated.
There is nothing wrong with paying more for an adjustment than you collected for the original trade. Assuming a trade must be made for appropriate risk management, then the true decision is:
Would you prefer to buy the position sold originally at its current price? Or would you prefer to make the adjustment at its present cost? You cannot do both. It’s edit or adjust.
Repeating for emphasis: The original trade price must play no role in this decision. You have a position – at today’s price. Nothing can be done to change that. You must exit, adjust, or do the unthinkable, and take more risk than your account (and psyche) can handle.
Do not foolishly throw good money after bad trying to salvage junk. But do not be afraid to make a solid investment that improves your chances going forward.