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

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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.

802

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6 Responses to When to Exit a Losing Trade


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