Trading and investing is a tricky business. If you’re on your game, you’ll get far more trades right than wrong. Sometimes the ego gets in the way of a clear mind and you end up holding trades longer than you should. There will be losses; it’s just part of the game. However, unlike gambling in a casino, where you have little-to-no edge, you can use the time-tested technique of technical analysis and charting to help keep yourself out of a difficult situation.
Let’s take a look at a trading case study using Twitter as an example (the chart is below).
A trader sees strong fundamentals when looking at Twitter and has been accumulating the stock for a while. The cost basis is in the mid-to-high $30 range. As of the close on December 24, Twitter stock is trading just under $23, so this person is likely sitting on a 30% loss or more.
The stock is well under the cost basis, but this investor continues to buy the stock on the way down, lowering the cost basis but increasing the risk of the overall investment. Did this person originally have a goal of accumulating a certain amount of shares or dollar value? Did this trader want the stock to go higher – or even lower?
Maybe this investor is a value player and sees enormous potential, as Twitter stock may be mis-priced. Why is the price going down, though? Institutions and insiders are selling the stock repeatedly. Don’t they know Twitter growth is going to continue over the long term? Don’t these sellers see this is a missed opportunity? There is a reason institutional sellers are active – they see lower prices ahead. Some of that instantaneous selling feeds on itself and prices continue to deteriorate.
If you look objectively at the chart, you can see there were few signs to get on board Twitter from the long side. Sellers have been hitting the bid and distributing the stock for months. If you owned the stock, you have been hammered. However, being disciplined and placing a stop loss at a certain level would have you out of the name before any major damage is inflicted.
William O’Neill, one of the greatest investors of our time, preaches taking no more than an 8% loss. Why that number? To recover that loss only requires an 8.7% gain on the next trade.
Back to our trader. Was this person unable to admit a timing error? I don’t know the answer to that question, but with more capital at risk it is certainly easy to cover up a mistake. This is a classic error that many novice investors make to help feed their ego. Unable to admit they are wrong or defeated on an idea, they tend to “double down” on a mistake hoping to get bailed out on a longer time horizon.
This is a terrible strategy. Putting more risk on a losing position just creates a bigger loser, more worry, and more doubt. In most cases, it just doesn’t work – and the opportunity cost (could the capital have been used elsewhere?) is enormous. Your mind may seem satisfied at the time, but there is no mistaking there is a bigger risk taken.
I have had plenty of trades go awry, but that doesn’t stop me from trading. I will let each trade stand on its own merit, and since I cannot predict the future, I accept that I will be on the wrong side of the trade at times. When that happens, I cut bait and move on.
You can learn more about the techniques I use in one of my most popular (and free!) e-books, The Art of Selling. Learning how to sell is one of the most liberating experiences ever. Download it today and see if you don’t agree with me once you’re done reading it.
Copyright: zestmarina / 123RF Stock Photo