Tuesday, February 9, 2010

The Value of being Wrong

Lets face it you are going to be wrong and you are going to lose money. That is just a fact of trading. If you can't handle it, then maybe you should try basket weaving or something. But just because you are wrong does not mean you get a get out of jail free pass. In order to survive in the market and make money on a consistent basis you need to learn from your losses. If you can't find the value in learning from your losses, you probably won't make it very long.

When you lose money on a trade it messes with your head and self confidence. It is very easy to become very destructive to your account value, trying to make up those losses in an attempt at revenge. It is also very easy to become discouraged and leave the market all together. This is a normal weeding out process that the market performs on a daily basis. You have to look at it this way, everyday the market is recruiting the top athletes in trading. And if you are not willing to work at this, the coach is going to cut you faster than you can blink an eye.

With every loss comes a learning lesson. The question is will you pick up on the lesson and adjust your trading accordingly? Look at it this way, you already paid the tuition so you better get the most out of it.

My own learned lessons:

During the current shift in the markets direction I gave back some of my profits that I had made during the past few months. This is not what concerns me as I know that losses are a part of the game. It is how much I lost and why. Since November I was up about 27% in my account or about $4,500 (As of the middle of January). In my opinion I was trading very well until about mid-January. I started to get lazy in my trade selection and analysis. I also started to increase my size in strategy's I had very little experience trading. I let the Euphoria of wining drive my trading. When you are trading from cloud 9, you get a false sense of confidence. You are almost convinced that you have the Midas touch. This clouds your judgment. So with that said lets look at a few mistakes that I made and what I have learned and how I will incorporate it into my trading.

1) After experimenting with the Iron Condor I had some trades that worked out well. I took the performance of this small sample of trades and made a generalization and did not consider what could happen if the stock moved beyond what the option market was pricing in. This leads me to my trade in NFLX. Previously in my prior 3 trades I was only playing with 2-3 lots at a time. But due to my performance over the past few months and the success trading the prior Iron Condors I decided to bump my size up to 10 lots on NFLX. As I had mentioned when I modeled out this trade I did not account for movements outside of what the options market was pricing in so going into earnings I was expecting a loss at most of $200, even though the max risk was at $1250. Based on the inputs that I adjusted this was the worst case scenario for me, boy was I wrong. The market was pricing in about an 11% move and NFLX shot up like 25% after its earnings release. I was immediately close to my max loss. Now instead of booking the loss and moving on I decided that I could out smart the market and try to repair the position only to make the losses worse. After I closed out the entire position I ended up losing about $1,500 (or about 33% of my gains).

So what did I learn:

a) Until you have enough data and experience implementing a particular strategy, keep you size small.
b) If you are wrong, don't throw good money after bad. Just admit you were wrong take the loss and move on.
c) When you are doing really well you need to be extra cautious with your trade selection. Cloud 9 "clouds" your judgment. You are not invincible.

2) Making money from the short side. I knew the market was changing, which is why I moved to almost 90% cash on January 14th. I was too quick to jump right back into the market. With in a week I was back invested to about 75%. I commented on an earlier blog about this. I want to implement a rule in my trading that every time I move to 60% cash or more that I can't invest more than half with in a 2 week period. With the $1,500 loss in NFLX along with another $1,500 that I loss on various long positions that is about a $3,000 loss. So I basically wiped out all of January's gains. I think that this rule would had saved me at least half of those losses.

Lastly I made the mistake of closing out my last purchase of SPY puts at the $108 strike. I set a game plan as to where I would buy my first lot and second lot. The first price target was triggered and I bought 5 puts for $0.95 a piece. The second price target was never triggered and neither was my stop. But I closed them out again for a small profit. Holding them for another day or two would had been good for a double and triple, respectively. So I am working on a rule that will help me stay short. I am open to any suggestions that you may have.

Good Luck Trading!

1 comment:

  1. I can tell you from my experience that all the rules you want to implement are only as good as your discipline to stick to them. This is my area of weakness. I have a history of just putting a trade on within seconds of seeing something I like, especially if I've been sitting in a lot of cash for a long period of time. I don't know if its built up demand or just lack of fear that allows me to just put something on without an in-depth analysis.

    I too had posted about being bearish and was calling for selling call spreads or buying put spreads, then I went and sold ATM puts which is essentially getting long. This is inconsistent with my current feeling on the market and perhaps could have been avoided if I had gone over my trade checklist before I put on an a new position. Since the spur of the moment decision making has been something I've always done, it's going to be hard to change that behavior. So here is a public notice to call me out on anything I put on that is contradictory to what I've previously stated, or just feel free to ask what my particular motivation was on an individual trade. I know that I often just list the numbers behind a new trade but don't comment on it.

    I agree with your comments of staying with a small size while you learn the ropes. I have some concern over your proposed trading rules for two reasons. The first is make sure you're implementing a rule that makes sense going forward and not something that would retroactively make your numbers look more comforting. Example: what if you had been up 20K but then lost the same amount on your recent trades. Would you still be thinking about the same rule changes for yourself? The second concern is as you've commented before, the markets are extremely dynamic, you might have valid reasons for changing direction on short notice. I'm worried that a self-imposed rule could disallow you from even correctly acting on your own information.

    As time goes on I think you stick with the basics when managing your money. Which for me are to stick with trades that you understand, go with position sizes and risk/reward relationships that reflect your capital standing, have predefined exit points that are only altered for a valid reason, and then just try to keep calm and not make snap decisions. This all sounds so easy but I have not been effective at it.