We all have things that we don’t like to talk about. For example, traders by and large are loath to discuss losing trades. Even though we all experience them. This is especially true of completely bone-headed ventures that one looks back on in retrospect and say’s “what the heck was I thinking about?” This is due in part to simple human nature and the need for affirmation (no extra charge for that bit of analysis).
It is also due to the fact that most of us have read enough advertisements over the years that we subliminally believe that there are traders out there who are so super successful that they almost never experience losing trades and are rarely even wrong about the markets. And who knows, maybe there are (if you happen to be one of them please contact me directly – I have some questions I would desperately like to ask). But you can rest assured, even if there are such people, they are few and far between. The rest of us have to deal with the reality of the markets.
Reality Ain't Pretty
I once knew a commodities broker from New Orleans named Mike. And despite the fact that he was a commodities broker he was a great guy. Go figure. Anyway, whenever a new customer opened an account he would offer them his “guarantee.” It went like this – “I guarantee you that you will experience losing trades.” It was probably not what most people wanted to hear but the fact of the matter is that he did them a huge favor by properly setting realistic expectations. Because in reality, besides being inevitable, a properly managed losing trade is nothing more than a cost of doing business. Therefore getting upset about a losing trade is an exercise in futility. It’s kind of like getting upset about your printer running out of ink. You knew it would happen eventually.
But when it comes to losing trades, there is losing and then there is really losing. Interestingly, there is also “winning while you are losing.” Please allow me to explain.
The Two Dangers with Losing Trades
One of the most important – but relatively unspoken – keys to long-term trading success is to keep any and all losing trades to a manageable – i.e., small, level. There are two dangers when it comes to losing trades.
1. Financial Danger
First off one has to understand that there is “losing” and there is “losing big” and then there is “losing catastrophically.” If one expects a worst case scenario of losing say 5% of their capital and then they lose 10% that is a bad thing. However, the fact remains that they still have 90% of their trading capital and are still very much in the game.
One the other hand a person who loses 50% or 80% of his or her capital is in a very different place. So clearly – and affixed firmly under the category of “duh” – smaller losses are better than bigger ones.
2. Emotional Danger
Now when I say “emotional danger” I am not talking about getting your feelings hurt. I am talking about the potential for a bad trade today to affect your thinking regarding another trade tomorrow or the next day or somewhere down the road. Like the person who touches the hot stove and gets burned, a trader who suffers an “unexpected” and/or “large”, and/or near instantaneous loss may be hesitant to act the next time his or her trading methods tell them to. Which is bad. In fact, for the sake of brevity let me just say that Murphy’s Law being what it is, the trades you don’t take will almost all be winners (hey, I don’t make the rules).
The Bottom Line
So the bottom line is this:
- Catastrophic losses are, well, simply catastrophic and leave you unable to continue, so clearly must be avoided completely.
- Losses that are larger (or which unfold more quickly) than are prepared to deal with emotionally (which by the way, for most people is less than what “you think you are prepared to deal with emotionally") can lead to emotional decision making in the future which is almost guaranteed to cost you money.
The best way to illustrate most things is with examples. Unfortunately, I have two.
Example #1: Crude Oil
Talk about being spectacularly wrong – I wrote an article dated July 14, 2011 titled “Crude Oil – Look Out Above?”. Based on some Elliott Wave analysis the potential for a strong advance seemed to exist. Oops. A mere 17 trading days later, ticker USO – the exchange-traded fund that tracks crude oil - bottomed out 16% lower. Wow. Hard to be more wrong than that. But like I said, there is losing and there is really losing. For example:
-If a trader had purchased September crude oil futures on July 14, then 17 trading days later he would have been sitting on a loss of over $15,000 (crude futures declined $15.35 a barrel times $1,000 a point).
In the article I highlighted two trades. The one I liked the best involved:
-Buying 2 USO Jan12 51 calls @ 0.51
-Selling 3 USO Jan12 57 calls @ 0.22
-Buying 2 USO Jan12 63 calls @ 0.11
With USO presently trading at $34 and change the prospect for this trade generating a profit seems remote even with over four months left until expiration. But here is the interesting part: the maximum risk on that position was $64. If this position was exited at the market at current prices the net loss would be all of about $44. The last time I checked, $44 was still less than $15,000.
Example #2: Soybeans
In a classic example of “Really Bad Market Timing 101”, on August 24 I wrote an article titled “Lean Bean(s)”
in which I highlighted bearish put ratio spread using November options. On that day November bean futures closed at 1393.5. Four trading days later they had screamed higher to 1457. So had you sold short one November soybean futures contract at 1393.5 and held on tight you would presently be sitting with an open loss of -$3175 (each point equals $50). Had you sold short one November soybean futures contract at 1393.5 and placed a stop-loss order at 1408 (above the previous recent high) you would have been stopped out in a two (lightning fast) days with a loss of -$725. Now consider the trade I wrote about which involved:
-Selling 1 Nov Soybean 140 put @ 51.375
-Buying 2 Nov Soybean 135 puts @ 27.375
As of the close on 8/30 this trade showed an open loss of $-194. Figure 1 displays the current risk curves for this position.
Figure 1 - Risk Curves for Soybean put ratio backspread
click to enlarge
-As you can see this position still has the potential to generate a meaningful profit if in fact beans do experience seasonal weakness between now and early October.
-Also, if beans were to keep rallying sharply higher from here there isn’t much additional dollar risk.
So like said, there is losing and then there is really losing. The two market timing calls I’ve highlighted here were awful. And so yes of course there is the “shame” that comes with being “a market guy” and getting it all so exactly wrong. But as I keep saying, there is also something known as “winning while you are losing.” While the timing of these trades could have hardly been any worse, the fact of the matter is that net total of these two trades is a combined loss of -$238.
Which I am pretty confident will not dissuade me taking the next trade. Get my drift?