Move the Markets

Evolution of a Trader: How to Recover from a Loss

Posted on July 29th, 2006
Written by Richard
Posted in: N/A (old archives)

“Ok, you wanna go up? Fine! Let’s go up!” It was December 29th, 2005, and I covered a losing short on Energy Conversion Devices, Inc. (Nasdaq: ENER) for a loss of $166. I had other losing trades in motion on Alkermes, Inc. (Nasdaq: ALKS) and Under Armour Inc. (Nasdaq: UARM), and the day was running out of trading hours. I needed to recover, and fast.

This is the second installment of the Evolution of a Trader series of articles. It’s a series about important learning experiences I had while developing as a trader. I spent a lot of money on these lessons… I hope you don’t have to! If you are new to the series, you might want to check out the introduction article, and the first installment.

Trading Loss Recovery Tactics

Continuing with the story from the first paragraph, I didn’t want to finish the day in the red. ENER had turned up as soon as I had gotten in short. It was especially hard to watch, because I had already pinned my hopes of making up for my other losses on this ENER trade. It wasn’t going to work! So, I reversed my position and took a $166 loss in the process. “Fine, let it go up,” I thought. “At least now it’s going in my direction.” Not only did I reverse the position, but I bought 5 times as many shares as I had sold in the short position. I should hardly need to tell you that it promptly started falling. I lost an additional $669 on the long trade.

It’s natural to want to end every day in the green, but like many beginning traders, I had all the wrong goals, and took all the wrong actions. That ENER fiasco was just one example, and unfortunately there are many in my early career. Here are some things I’ve done in the name of loss recovery, at one point or another:

• I held on to a winning trade too long because it had not yet made enough money to cover an earlier loss. “C’mon… Just a little more… I have $500 losses to make up for…” This line of thinking creates an irrational tie between the performance of one trade and the performance of another. It causes you to ignore your trading plan, and can not only reduce profits, but even turn winners into losers!
• I jumped out of a winning trade too early because it had made enough money to cover my earlier loss. “I can’t risk going red again for the day.” This is a variaton on the above irrational thinking. If the trade is still good, don’t alter your trading plan.
• I overtraded to make up losses by the end of the trading day. “This isn’t the best setup, but it’s almost 3pm, so…” If you get fixated on getting back into the green by 4pm, desperation can make bad setups seem good.
• I traded too large a size so that a trade’s likely reward would cover my losses. “Let’s see… I need to make $500, and I can maybe get 20 cents… so I’ll buy 2500 shares.” That’s ignoring the proportionally larger risk, of course. I don’t have to tell you how this turns out, do I? I did this in the ENER example above.
• I traded for revenge. “Revenge Trading” is when you trade the same stock that you lost money on, but you are so focused on “beating” the stock, that you lose some or all of your trading discipline. The hasty long/short reversal from the example is a kind of revenge trading.
• I associated new trades in my mind with the hope of making up my losses. From the start, this puts emotional ties on the trade, and it exacerbates all the other items on this list. Any book will tell you that “hope” is a four letter word in the markets, but I bet every trader in existence has fallen prey to this illness at some point in their development.

I’m sure a lot of aspiring or beginning traders will read through this list and laugh. Of course they would never do those things. When you read them in a list, they do seem like stupid thoughts to have at all, much less act upon. But, when you are down thousands of dollars, and you have bills to pay, and you know that so-and-so is going to ask you how the day went in a couple hours, and they obviously already think you are an idiot for trading stocks in the first place, and you’d really like to impress them… well, somehow your brain manages to blind itself to anything but the possible upside of plans like the ones above. If not, you are luckier than I was! On the other hand, if you do find yourself having thoughts like these, I hope they’ll seem familiar from this article, and you can avoid my mistakes.

The True Nature of Recovery

Eventually, I had a revelation. “Recovery” is not an action that you take. It’s not a course of action you can plan. It doesn’t even have anything to do with your account balance, or whether the markets are open. Recovery is a state of mind.

Specifically, it’s the state of mind you were in before the loss. Think about it… If you have a positive expectancy (and a reasonable win rate), you will make back more money than you lost before long. At least, the odds are overwhelmingly on your side. And you don’t even have to do anything special. The only part of the bargain you have to hold up, is you have to trade the way you did when you measured that positive expectancy. When you focus on the loss, or attempt to take an action that you think of as “recovery,” you are making adjustments that put you in a state with unknown expectancy. The type of changes a beginning trader is likely to make will almost certainly lower his or her expectancy, if not make it negative. And off they go down the spiral of further losses and more urgent recovery “plans” and “attempts.”

In Jack Schwager’s The New Market Wizards: Conversations with America’s Top Traders, Linda Bradford Raschke says “It never bothered me to lose, because I always knew that I would make it right back.” If you measure your performance, and you have a reasonable system with a positive expectancy, you could make the same statement.

So, in a very zen way, the moment you stop trying to recover is the moment you will succeed. I can now say I’ve recovered from my latest loss without having made back a dime yet. Sometimes I need to take a walk. Sometimes I need to take the rest of the day off. I don’t trade again until I’m mentally back to where I was, pre-loss. Over time, it has gotten much easier to get there.

An Aside: Mental Discipline

A lot of the pitfalls that Type 1 and early Type 2 traders fall into really boil down to a lack of mental discipline. The thoughts I listed above may lead to counterproductive trading behavior, but they are all rooted in perfectly natural human emotions and dispositions. For me, they key has been to stay aware of my thoughts. That way, when I have counterproductive thoughts, I can recognize them for what they are and dismiss them. They still pop into my head today when I’m trading in the red. For instance, during my trade on United States Steel Corp. (NYSE: X) this week, I found myself watching the dollars of profit, waiting for it to surpass my earlier loss on CSX Corporation (NYSE: CSX). I quickly noticed and forced my attention back to the quality of the price action. Problem averted.

Reading trader blogs, I’ve noticed that several of us are into meditation, and I don’t think that’s a coincidence. A lot of people think meditation is for relaxation or spirituality, but first and foremost it’s about mental discipline. At the beginning, it’s actually really hard work! Being able to observe your own thought stream passively, and stay entirely focused on one thing for minutes on end, are excellent skills for any trader. I recommend that all traders try it.

Summary

That number on your trading platform screen isn’t labelled “Profit/Loss/Drawdown/Recovery,” is it? Of course not. Actions you take only result in profit or loss, plain and simple. Everything else is really just your mental picture of your equity’s health. If you let that picture alter your trading decisions, you are entering a zone with unknown expectancy, and will probably suffer for it.

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© 2010 Richard Todd. I am not a financial advisor, and nothing on the site should be considered investment advice or actionable recommendations. I'm just an individual, saying what I think, and sharing my experiences.