Monday, March 29, 2010

Psychological Breakthrough

Today I closed out a trade for about a $40 loss. In the past this would have drove me nuts and I would have rather gambled further and continued holding, thus taking on risk, than take the small loss. Especially once I started tracking my win/loss percentage taking even a small loss was somehow looked at as failure. I was more concerned with an internally generated scoreboard rather than the total profit and loss. I used to want to book a $1 gain than a $1 loss. This makes no sense as a win percentage of 100% means nothing if they are all $1. But now that I'm planning on keeping the average $ and % gains and losses in addition to the overall win/loss percentage, it allowed me to take the small loss and see things in the big picture. I'm no longer concerned with the win/loss percentage on a stand alone basis and instead more concerned with the combination of the average $ and % gains/losses.

Example 1:
70% wins looks good on paper by itself. If that were all I was tracking I would be happy psychologically. But if my average gain was $500 and my average loss was -$2000, then your expected loss should that trend continue is negative, (.70)(500)+(.30)(-2000) = -$250.

Example 2:
55% wins, average gain = $500
45% losses, average loss = -$200
Just eyeballing the percentage alone I would be thinking that after commission you're not doing very well unless your position size is large, which I'm not. But the combination of the dollar amounts and win percentage tells me much more and will allow me to cut even small losses in the future without effecting me nearly as much psychologically as in the past

I believe psychology plays a large part of investing and that's part of why the efficient market hypothesis is crap. It took me a long time to sell something at a loss, especially if it was a large loss, if it was no longer something I believed in. I felt like I was stuck with it and I had to keep it, even it meant five years, it has to come back in the long run right? Wrong, but it took me a good number of years to get comfortable with accepting a loss and moving on. So had it not been for this blog forum I don't think I would have added the average win/loss to my spread sheet which I now feel has helped me manage risk better.

3 comments:

  1. Congradulations on the break through. I agree I really think that the different metrics that I am starting to track are going to be very useful in the long run for risk managment and also to help through drawdowns once you have collected enough data.

    By the way I added a few things to my page to kind of give you an idea of what I was envisioning.

    http://optionstrader-shareandcritique.blogspot.com/p/dominic-di-bernardo.html

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  2. I too had a psychological breakthrough this morning. I have always talked about taking part of a position off when it moved in my favor, but have never been able to actually pull the trigger. Because I was under the mentality that it was all or nothing. But I think physiologically it is going to do wonders for me. Because I can book some profits and stop the rest for break even. I might have a few more scratches but I think it will allow me to let my winners ride longer and capture some of that profit I am always talking about leaving on the table. It only took me 10 months to finally act on something I have talked about doing for so long.

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  3. I don't believe I've ever took part of a trade off the table. I'm pretty much all or nothing. I think part of the reason is I don't buy in to the mentality of "playing with the house's money." To me, leaving a trade on is the same as implementing it again as you've got the option to pull the money down and take zero risk going forward. Another reason is probably due to my personality. I would immediately look at taking half a position down as a lose/lose. If the stock goes up further I'm an idiot and took profits too soon. If it goes down I'm an idiot because I could have taken it all off and didn't. I will admit that is a personality flaw that probably gets in the way of what should be done. I'm glad you were able to finally do something you've been talking about. If you're like me, you'll be half excited but the other half will immediately question why it took so long.

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