Ten simple rules to avoid large trading losses (with CDFs)

This article is published by CommSec and is intended for CFDs. However the techniques seem to be quite useful for other derivatives and even trading stocks directly.

"Avoiding the commitment to failure

In theory, when a trader experiences a decline in the value of an investment the desire should be to exit the position. But often the opposite occurs. A behavioural concept known as ‘escalating commitment to a chosen course of action’ can be the downfall of a trader, especially when using a leveraged product such as contracts for difference.

Forced compliance studies induced individuals to perform unpleasant or dissatisfying acts in the 2003 text The Social Psychology of Organizational Behaviour, edited by Leigh Thompson. Because the individual could not undo the consequences of the act, it was found that the individual biased his attitude towards
the experimental task so as to reduce any negative outcomes resulting from the behaviour. By justifying prior behaviour the decision maker increased his commitment in the face of negative consequences and the higher level of commitment in turn led to further negative consequences.

Probably the most famous example of escalating commitment to a chosen course of action was the Vietnam War. In a 1965 memo from former Under Secretary of State George Ball to US President Lyndon Johnson, Ball wrote “Once we suffer large casualties we will have started a well-nigh irreversible process.
Our involvement will be so great that we cannot - without national humiliation – stop short of achieving our complete objectives.”

In the trading world, once a trade turns bad a trader can rationalise his bad decision and increase his commitment by either staying in the position as losses grow or by adding to the position in what is commonly known (with long positions) as averaging down.

When a losing trade is not exited quickly, because of the leverage factor, losses can mount exponentially. Nick Leeson’s futures trading in Singapore in the 1990s was an example of an escalating commitment to a chosen course of action in a leveraged product. But small private traders managing less spectacular
amounts of capital should also be aware of the phenomenon because it is not uncommon for small traders to end their trading career with a single catastrophic trading loss.

Some simple rules can help you to avoid the big loss and stay disciplined:

1. Trading is a 50-50 prospect. A trader can win less than 50% of the time and still be profitable. Success or failure is not due to the amount of winners you pick but rather the dollar return on winning trades versus losing trades. In other words, be consistent with your risk amount and stop losses and aim to make your wining trades larger than your average losing trade.

2. Markets don’t behave rationally therefore sticking to a losing trade can never be rationalised. Prepare mentally and financially for both scenarios before you enter the trade - winning and losing - by placing stop loss orders and identifying possible price points where the trend may become exhausted.

3. A study of multiple choice examination habits has shown that going back and changing answers increases the chance of being wrong. Never move a stop loss level once it is set, unless it is in the direction of the trend you are trading.

4. Moving a stop loss order with the trend will help you maximise profits because you are changing your exit level in accordance with the market direction. Some experts advocate never exiting a trade unless it’s on a stop loss order – any other approach is effectively picking a top (or bottom).

5. Always aim to place a break-even stop-loss order after your initial stop loss order. A break-even stop is a free ride. No one ever went broke from not taking losses.

6. Choosing not to trade can be more difficult than taking a trade. When there are no good trading opportunities it’s best to sit on the sidelines.

7. In a bull market your goal is to make money from the upside and in a bear market your goal is to make money from the downside. In other words, it’s smarter to look for short trades in a bear market.

8. The middle of the trend is the “meat in the sandwich”; the beginning and the end of a move are inconsequential. If you want to be profitable only trade the middle of the trend.

9. The bull market for stocks has created a bullish bias. Therefore stocks that are breaking down can do so more quickly than rising stocks as the majority of traders exit long positions. Be prepared to act quickly in a falling market.

10. Information such as technical indicators and economic news can be used to justify a losing position. Price is the ultimate arbiter of value. Follow the price. "

As with all other articles on this blog, this article is not considered financial advise, but merely for thought and discussion.