October 3, 2015

Big loss in stock markets?

If you have incurred a big loss in the stock markets, then spend some time understanding what exactly went wrong.

For eg., some common reasons could be:
1.trading long instead of trading short
2.taking a position in derivatives instead of cash
3.taking a position far bigger than mandated by risk management
4.lack of any system in trading
5... any other reason you can think of.

The first situation is common and happens when you take a short trade fully knowing the trend is up simply because you feel the stock has run up a lot and it should start correcting. In my view, this is a stupid way to trade because you are trading your emotions and not the chart so if you have lost money, you rightly deserve to lose. The other situation is you trade a breakout (long) and smart money shorts the stock. Here you followed your system, traded in the right direction but  what you got was a breakout failure. Don't worry this can happen half the time but will not cause losses.

In both cases, the outcome is not in your hand. But what you can control and this should be a part of your plan before you trade is what will you do if your trade goes wrong? If you have a plan (exit strategy) then you will automatically be out of a trade but if you have no exit plan in place, then you will be just left hoping and praying for a situation to get out with some dignity.

Point 2 and 3 are essentially the same. Trading beyond your means or taking a leveraged position is essentially the same thing. The keyword here is taking a position more than mandated by "risk management".

Risk management is the most most important part of any trade and you will realise this as you move along from a novice or amateur trader to a professional trader. Once you learn to manage the risk, everything will fall in place. First, your losses will start becoming smaller and as this happens, your profits will automatically coming in.

Risk management at the most basic level is simple. First define your stop loss (this should not be some random figure but a sensible one which takes into account the average trading range of a stock). Second, define what percentage of your capital you are willing to lose on a wrong trade. Ideally this should be less than 1%. The beauty of risk management is once you quantify this before taking a trade, the loss does not hit you or affect you emotionally whenever a trade goes wrong.

The last point is lack of  a system. Whatever you do, you should always have clearly defined entry and exit rules. A very simple and extremely powerful rule could be consider a long position only if a stock makes  a 52 week high. Or buying  a stock closing above last 2-3 months highs. Now having a system is one thing but not being able to follow it is another (bigger) problem. So you design a system you are comfortable with and what happens in real life is your first 4-5 trades whipsaw with the result you start having second thoughts about your system or fall prey to redesigning or attempting to improve a perfectly fine system.

Other factors

Timeframe: For the same system, a smaller timeframe is likely to produce more trades and whipsaws than a higher timeframe. The emotional roller coaster one goes thru day trading whipsaws is far worse than someone who takes  a position for few weeks or months. So a system like 3 bar swing will give fantastic results on monthly charts and average results on daily charts and worse results on hourly or 15 min charts.

Put conversely, it is the same as saying that for same system, higher timeframe investors have a higher chance of earning money as compared to lower timeframe traders (day traders?). This is also borne by real life experiences - the richest people are all investors holding for months or years. You will never hear day traders being amongst the richest folks.

Discipline: No trading can be complete without this very important factor. I have not mentioned this before but whenever you talk of any rule based trading or inability to manage losses, the culprit is always discipline. It is no use having a fancy system or risk management rules when you have no intentions or are simply unable to follow these.

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