In Friday’s options post, we talked about the tendency of options traders to become enamored of a particular strategy simply because the trader is on a brief winning streak with that specific strategy. This propensity is particularly dangerous because market neutral income options strategies typically are entered monthly. So even a mere four month winning streak—only four successful trades in a row–allows the trader four full months to slowly convince himself that he has in fact found the holy grail and that his picture will soon appear on the cover of Barron’s as the next great options trader of our generation.
I work very hard with my mentoring students to keep their capital levels under control until they have an adequate sample of results to be able to prove to me and more importantly to themselves that they are ready to trade with more size. The deal I make with them is very simple—you can increase your capital as soon as you have a LOSING month utilizing the exact strategy with which you have been experiencing so much success.
Why? Well, there are several reasons. First off, a loss allows the student a critical opportunity to take a fresh look at the strategy. Is the strategy perfectly valid and have I simply experienced a predictable loss? Or did the loss itself show me a critical flaw in the strategy that must be corrected? If there is something structurally flawed in the trade, and it is correctable, then I recommend that the student employ the same strategy, revised for the flaw, for a while, at the same capital level, until it is clear that the kinks have been worked out of the strategy.
Perhaps a more important reason to defer increasing size until a loss occurs, is the psychological implication of experiencing a loss on a trade where the student had previously enjoyed a winning streak. How did the student handle the loss? Was the student able to take the loss objectively as part of the game, or was he or she devastated?
No one I have ever met LIKES losing on a trade, but I have met many talented traders that can shrug off losses fairly easily. If the student is easily able to “get back on the horse” after a losing trade with a perfectly valid strategy, then the current capital level has proven to be appropriate for that trader, and it is safe to experiment with a judicious increase of capital size. If on the other hand the trader is devastated by the loss, it may be a sign that the CURRENT capital level is too large and it might be advisable to actually reduce capital size.
So don’t increase capital size until you experience a loss for a particular strategy. Then you’ll know if the strategy is valid and more importantly, that you can psychologically handle an expected normal loss at your current capital level.
You will save yourself a lot of aggravation, and money, if you follow this simple rule.
7 Comments on “Are you REALLY willing to get back on the horse?”
Hey, this really works.
I decided I wasn’t going to increase size until I had losses, and now I’m trading huge size.
thanks
interesting approach. thanks for sharing.
Jo Jo, the important thing is to get to your desired capital level very slowly, so that you can truly gauge whether you can tolerate your maximum loss limits at each level of capital. If you get ahead of yourself capital wise, it creates very serious problems from which you may never recover as a trader. So please be extremely careful about capital levels.
Case in point…
A relative of mine shorted AAPL at $135 12-18 months ago. Huge position.
AAPL approached $150. He didn’t cover. $185. $210. His short turned into a “core” position.
He finally covered at $215-$220. Lost multiple six-figures.
He thought he could control the market, but he could barely control himself.
David, I’m sure that that was a discouraging experience for your relative but I think this story gives us the opportunity to point to a couple of key trading axioms that all great traders follow–you MUST have a plan for each trade and you MUST have a maximum loss for each trade. Also, I think we all have to fight the tendency to want to be right, when the market is clearly proving to us that we are wrong. With a solid plan that contains a hard stop when our maximum loss is hit, we force ourselves to accept that we were wrong, which of course is the key to surviving long term as a successful trader. The market is always right, WE are the ones who are either right or wrong. Thanks for sharing this cautionary tale. If your relative had made a plan at the beginning of this trade, I am confident that the plan would NOT have included a multiple six figure loss.
Outstanding rule. I like it!
amen!