October 22, 2007 at 6:25 am | | Comments 1

When Good Trades Go Bad

Last week, the market took a turn for the worse. A move like we saw on Friday inevitably leaves more than a few traders caught off guard as they watch profits evaporate and losses escalate. Take for example the energy sector, which has been such a leadership group for many months. Numerous stocks within the group took quick dives after making 52-week and, in some cases, all-time highs. This likely left many traders scrambling to make a decision – sell or hold?

Many traders tend to gravitate to the strongest sectors and the strongest stocks within those sectors for trading. This is a good approach to trend-following, but what happens when a move like last week comes around and you get smoked? A reader e-mailed me over the weekend with valid questions about this very topic. Here were a few of my solutions. My answers were applied to the energy sector which this trader has been playing, but it applies across the board to those individual trades which sometimes just turn and misbehave.

When a trade goes bad, cutting losing positions has several benefits.

For one, it will free up cash which can be used for other trading ideas. If your capital is tied up in a trade in which you are wrong (losing), you are suffering opportunity losses. A cash position is better than a losing position (and cash IS a position). Other stocks could be showing you a gain, so consider at least partial sales to free up cash for new ideas, possibly even on the flip side.

Secondly, selling or lightening up on losing positions will help to free up your mind and help you start fresh. Leaving some mental baggage behind is always a good idea – none of us want it! Some of my worst stretches of trading were a result of having just one losing trade on my screen which I should have already kicked to the curb. I would turn my screens on in the morning and there it was looking back at me. This not only put me in a poor frame of mind to begin the day, but it had effects on other trade ideas I should have taken but was afraid to put on because I didn’t want to lose any more. A losing position should be cut down in size at a minimum, and often times should be cut completely. Starting fresh allows you to get back to your big-picture game plan of taking trades in good setups without the mental baggage of big, ugly losers which weigh down your confidence.

Finally, a losing position should be cut because you are flat out wrong. Naturally, stopping the loss will save your hide! Some traders refer to losing positions as “paper losses” and convince themselves of the old argument that “it’s not a loss until you take it.” This could not be further from reality, because the damage has already been done. The market is telling you what the stock is currently worth. Take some responsibility – those red numbers mean you’re on the wrong side and it’s time to get out and stop the pain.

So the next time your stocks take an ugly turn, remember to at least lighten up on your position. You’ll reap a number of benefits and immediately feel better about your next trade!

Don’t let a losing trade turn you into a loser!

10/24 UPDATE: Jonathan over at A Trade A Day expanded on this concept and has made some excellent points along these lines. Check it out.

Jeff White
President, The Stock Bandit, Inc.
Swing Trading & Day Trading Service

[tags]Stock Market, Day Trading, Stock Trading, Investing, Swing Trading[/tags]

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