If you can't accept failure, perhaps you shouldn't be trading without extra steps to protect your trade.
The other day, I dropped into a chat room at my brokerage and happened on traders comparing how much they'd lost on long bets on DRYS.
Weekly Chart of DRYS:
Yikes, with a chart like that, it was easy to understand losses, isn't it? Yet some other posters on the chat were asking with only barely concealed consternation why the losing traders had let the losses grow so large. "Hadn't you been using a moving average or something as a guidepost?" asked one.
It's not hard to imagine a hundred reasons why the affected traders had held onto a losing trade while DRYS dropped.
Potential Support Levels on the Way Down:
Although DRYS is optionable, the stock price was cheap enough that some traders might have been buying the stock, anticipating a bounce at one of those two potential historical support levels. From the comments made, I suspect some traders had indeed bought the stock just above or below each of those two potential support zones.
As is visible from the chart, when each of those two potential support zones broke, the price drop was precipitous. That quick drop could have surprised some traders with a loss bigger than they'd anticipated before they could get out of the trade. They might have then held on, thinking that DRYS had to turn around.
Obviously, it didn't have to do anything.
What lesson can we learn from this? It's not that the trader should have used a different method for determining potential support. For example, we could throw a moving average up on the chart. We could postulate that the trader could/should have used the appropriate moving average as a gauge that DRYS' price was dropping below support, exiting the trade when that support was violated. We could have used some sort of channeling system. But the loss of either of those types of support could result in a precipitous drop, too, once market participants realized that buyers weren't stepping back in. If the traders involved in long DRYS trades tended to be subject to deer-in-the-headlights paralysis or fear of failure intertwined with hopium, a moving average or channeling system wasn't going to accomplish anything different than a horizontal potential support level did.
If any of our readers was involved in a big loss on DRYS, this article isn't meant as a chastisement. We all have trading failures and failures to act appropriately, too. So, what do you do about it?
First, recognize that we all fail. Our scenarios don't play out as expected. Our underlying gaps lower and our loss is bigger than we intended. Once we realize that we're all going to fail at some time or another, either through our own mistakes (since we are human, after all) or natural market forces, then it's incumbent upon us to decide when we can trust ourselves and when we can't. Perhaps we can usually trust ourselves to exit a trade when needed but we're trading a strategy or an underlying or in a size that makes us nervous. A nervous trader isn't one who will calmly pull the plug on a trade when confronted with a sudden move against the trade. It's time to cut down the size of that trade.
If your inexperience or recent life experiences render you less able to accept failure than at other times, it's time to limit risk. Instead of buying 4,000 shares of DRYS when it hits $3.00, it might have been a better idea to buy 400 shares. It's amazing how much easier it would have been last September to accept a sudden loss of $184.00 plus commissions when DRYS dropped from $3.00 to close the week at $2.54. Perhaps some of those who followed the stock all the way through to February would have been more willing to exit the trade at $2.54 and wait until DRYS proved itself before going long again if their losses had been smaller when DRYS first broke through one of those support levels.
Another way of managing that fear of failure could have been to structure an options trade so that risk was controlled from the inception of the trade. Perhaps back on September 10, when DRYS was at $3.10, the trader with a intermediate-term bullish outlook could have bought 10 DEC14 3 calls at $0.37.
Buying 10 Calls:
While allowing the trader to participate in gains before December expiration, this trade would have limited the risk to the amount paid for the calls, $370 plus commissions. The trader who couldn't trust herself because she'd just lost money on two previous trades and was in a have-to-make-a-profit-to-make-it-up state would limit risk, whether or not she could trust herself to exit at her planned exit.
The use of a spread trade could also have limited risk, although a spread trade would also have limited participation in an upside move. Limiting participation in an upside move isn't the worst thing you can do as a trader, though. Undermining your trading capital or your confidence in yourself are far worse.
You'll notice that I haven't yet mentioned the use of stops to limit risk. Of course, it's important to use stops when appropriate to limit risk. If the trader's concerns center around the unfamiliarity of the underlying or strategy or the volatility of the underlying at the moment, there may be concern that a stop loss order will result in a bigger-than-anticipated loss if the underlying's move is an adverse one. Still, setting stops are a great idea . . . for traders who can trust themselves not to move the stops.
The main reason that setting a loss wasn't the first tactic discussed, however, is that it is so, so easy to move a stop. Imagine a morning when the trader wakes to find bad news on the underlying or the industry to which it belongs. Anticipating that there might be a knee-jerk drop in the stock price at the open, that trader might be tempted to pull the stop order until he can determine whether the early drop will be reversed. Sometimes they are. Sometimes, they aren't.
The trader who has just heard that there might be some layoffs at her work place won't be in any mood to lose on a trade. Seeing a move mid-morning one day, with the underlying's price dropping toward a previously set stop, she might be tempted to rethink that stop. And then the stock price plummets. Some days, drops are straight down, with each little jot upward met by strong selling that rolls the price down again.
This article contains no secret techniques. It's not meant chastise any readers if they happened to be among those who followed DRYS as it moved lower, always thinking that it had to turn around. As was mentioned earlier in the article, we have ALL been there sometime during our trading careers if we've traded long enough. This article is meant to warn you to recognize those times when you can't trust yourself to set and adhere to stops or to take other steps to control risk. If you can't trust yourself, you should give serious consideration to constructing the trade so that the risk control is built in.