T2W Trading Community

Fearing Losses

There is a huge difference between being risk averse and fearing losses.  You must hate to lose.  In fact, you can program your brain to find ways to not lose.  But not losing is a logical thought-out process, rather than an emotion-based reaction.

Two human-based tendencies come into play.  The first is the sunk-cost fallacy and the second is the exaggerated-loss syndrome.

Sunk-cost fallacy:  You are in a trade that begins to go against you.  You reason that you have already spent a commission, so you have costs to make up for.  Moreover, you have spent time and effort researching and planning this trade.  You reckon that time and effort as cost.  You have waited for just such an opportunity and you are afraid that now that it has come you will have to miss this trade.  The time spent waiting for opportunity is something you also count as cost.  You don't want to waste all these costs, so you decide to give the trade a little more room.  By the time you realize what you’ve done, the pain is almost overwhelming.  Finally, you have to take your loss which is now much larger than it might have been.  The size of the loss adds to your fear of ever losing again.  The end result is brain lock and inability to pull the trigger on a trade.

Exaggerated-loss syndrome:  You give the importance of losing on a trade two to three times the weight of winning on a trade.  In your mind, losses have greater significance than wins.  In reality, neither is more or less important than the other.  In fact, wins do not have to be as numerous as losses as long as the wins are significantly larger in size than the losses.  Of course, best is to have more wins than losses with the wins greater in size than the losses.

What should be done? 

Evaluate your trades solely on their potential for future loss or gain.  Ask yourself, “what do I stand to gain from this trade, and what do I stand to lose from this trade?”  Think the matter through.  “What is the worst thing that can happen to me if I take this trade, and do I have a plan and a strategy for extricating myself long before it happens?”  “If I begin to lose, is there a way I can turn things around and come out a winner?”  Learn to look at the costs of a trade as part of your business overhead.  Try to have a mind set that you will not throw good money after bad.  When you give a trade more room, you are doing just that – often throwing away money.

Valuing Invested Money More than Won Money

Traders have a tendency to be more careless with money they’ve won than with money they’ve invested.  Just because you won money on good trades doesn’t mean you should gamble with that money.  People are more willing to take chances with money they perceive as winnings as though it were found money.  They forget that money is money.  Valuing money depending on where it comes from can lead to unfortunate consequences for a trader.  The tendency to take greater risk with money made from trades than with money invested as capital makes no sense.  Yet traders will take risks with money won in the markets that they would never dream about with money from their savings account.

What should be done? 

Wait awhile before placing at risk money won on trades.  Keep your trading account at a constant level.  Strip your winnings from your account and put them in a safe conservative place.  The longer you hold on to money, the more likely you are to consider it your own.

Forgetting About Margin Inflation

Before the crash of 1987, S&P 500 stock index futures carried an exchange minimum margin of about $12,000 .  Immediately after the crash, margins required by some brokers rose to $36,000 and higher.

A trader we know, called Willie, figured that if prices on an index he was short went down, he would continually add to his position whenever prices first pulled back and then broke out to new lows.  The index he was trading became very volatile, and his broker raised margins to by 1/3rd.  Willie was trading a small account, and when he tried to sell short additional contracts onto his already short position, his broker would not allow him to do so.  Willie complained bitterly, but the broker was adamant in his refusal.  The broker would not allow Willie to use unrealized paper profits to cover the additional margin required for adding on.  He explained to Willie that to do so would in effect allow Willie to build a pyramid position and that was not going to be allowed by the broker's firm. 

The mistake Willie was making was what some call the “money illusion.”  Willie assumed that because his position was moving in his favor that he had more selling power and more margin.  His broker quickly brought Willie face to face with reality.  While some brokers may allow it, unrealized paper profits do not truly constitute additional funds that may be used for margin.  Willie’s dream of fabulous profits from this trade were just that, a dream.  Willie should be thankful that his broker did not allow him to get in trouble.  Pyramiding with unearned paper profits is not the way to succeed as a futures trader.

What should be done? 

You should realize that each so-called “add-on” to an open position is really a whole new position.  Each add-on carries all new risk, and each add-on brings you closer to the add-on trade which will fail and become a loser.  When planning a trade, be aware that if the market becomes volatile, margin requirements may go up, thereby defeating any strategy for adding on to your position.  There is nothing wrong with building a position one leg at time as prices ascend or descend, but when volatility dictates an increase in margin requirements, beware of trying to add on and be aware that you may not be able to add on. 

Option sellers can quickly get into similarly difficult positions.  As they roll out to new strikes to defend a threatened short options position, they can find themselves not only facing the need for a larger position, but also facing increased  margins in creating that larger position.  They may discover that they no longer have sufficient margin to defend a particular position and thus have to eat a sizable loss.