Comment by k1

View Single Comment

k1
November 8th, 2007 at 5:33 pm
Controlling Downside

Getting even on a loss is a gift

One thing we should talk more about, as I see this mistake made a lot, is that Losing Less is the same as Making More. This is something I don’t think a lot of people get. When you have a loss and you get even – be happy, get out or lighten up as you were obviously wrong when you entered the trade so maybe you’re still wrong and just lucky at the moment. Always keep in mind that time works against you so, with a November contract – if you entered 2 weeks ago and were totally screwed last week and now (with 8 days left) you get even – why risk it? If it goes against you tomorrow you only have 7 trading days left to get lucky again and it took you two weeks to get lucky from last time.

Cutting losses to the downside

Never allow yourself to lose more than 20% of a full position. So if a full position for me is $5K, I would buy in $1K blocks. If the first block drops 20% I think long and hard about how much I still like it. This represents just 20% of 20% of my full position (4%) but that’s no reason to be cavalier about it. If I stop out, little harm done, I can make 5 mistakes like that before I wipe out one gain. If I still like it, I may decide to buy another round (and reduce my basis 10%) or just wait for a move either way. At around minus 30-40% (on round 1 only) I will then make a decision to stop, double down or roll the contract. Once I get into round 2 (40% committed) I then follow normal stop rules again EXCEPT, after a DD or roll, my goal is to get half off the table even, leaving me with my original bet at a lower price than I intended to pay.

Don’t get boxed in

While I’m very good at “saving” positions, I see too many people who simply run them into the ground until there is no hope of recovery. When you are down 20%, you have perhaps 4 options, DD, Roll, repostion, sell. When you are down 40% perhaps the roll goes away. When you are down 60% the reposition probably no longer makes sense, when you are down 80% the DD isn’t even an option and, when you are wiped out, it’s too late to sell. This is how people let themselves get boxed into a corner with no way out.

I get wiped out on positions all the time but no position is ever more than 5% of my portfolio (other than an index cover) and usually the ones I get wiped out on are significantly smaller than that – often small initial entries that go the wrong way too fast and simply aren’t worth saving. The simple fact that you are worried about a position means it’s probably not risk appropriate for your portfolio but that’s a whole other subject that Sage and I went over in our “Smart Portfolio Management” series (probably under the educational tab).