In April 2017, I had a real nightmare. I had been trading full time on the market for four months and had had enormous success buying bubbley story stocks and riding them upwards. I was convinced that I knew what I was doing. I made all the classic mistakes of complacency, which turned into denial as liquidity dried up, and eventually horror as I watched myself lose money at a magnified rate (I was levered) day after day.
It forced me to take a real hard look at myself, and what I was actually doing. The reality was that I had no idea, and that if I didn’t change my ways then I’d be dusting off the CV.
In this article, I hope to offer some actionable tips to improve your P&L.
Exits are far more important than entries
One thing that emerged from my self-scrutiny was that my exits were all over the place. Random, chaotic, and inconsistent. Which – unsurprisingly – showed up as random, chaotic, and inconsistent results in my P&L.
As traders, we love high probability entries. I find it a lot easier psychologically being right more often than I’m wrong – though that’s not to say trading systems with low probability entries do not work. They can do. It’s just that I don’t use them.
But it’s the cumulative exit prices of your trades will determine your P&L. That means that the exit strategy is far more important than the entry.
Dr Van Tharp has proven that it is possible to make money on random entries if you have good exits and risk management.
Therefore, any trading system should have absolute priority on the exit strategy.
Building an exit strategy
I believe that before entering any trade that we should have an exit price both to the upside and to the downside. If you don’t do this, how do you know when you’re going to exit? The outcomes for not doing so are serious:
- If the stock rises, then complacency builds
- If the stock falls, then we are tempted to hold onto a loser
As we can see, both of these options are dangerous to our wealth. It sounds dramatic, but we are only ever one bad trade from blowing our accounts.
For those who attended Mark Simpson’s excellent talk at Mello last year, he spoke about fund manager Bill Miller who averaged down on several stocks and wiped away a large part of his career’s outperformance in just a handful of trades.
The problem with averaging down is that there is never any guarantee that the stock will come good. With an exit strategy, you can at least guarantee that you will close the stock on your terms and not terms that are forced on you.
As a trader (remember this is a trading blog) it is a sin to average down. Doing so is to fight against mathematical rules, which are much bigger and much tougher than you or I.
I prefer to cut my losses at a maximum of 25%. At this point, it’s only a 33% return to breakeven. But at a 30% drawdown its nearly 50%. The numbers start to exponentially work against you the further the drawdown you take. The vast majority of my losers are cut well before 20%.
If you do not have an exit strategy in place for all of your positions right now, it may be worth loading up the charts and looking through your stocks.
Look at the market value (not cost). The market doesn’t care where you bought at, and neither should you. What matters is what the price is now and the price action.
- Is the stock at a key support level?
- Is the stock through any significant moving averages?
- What’s the volume like?
Take time for an evening review
To avoid complacency, making an evening review part of your daily routine will defend against this.
Buy a diary, and start keeping a journal. Once you build this habit, it will become easier to question your trades. Simply by writing about what happened that day, what can happen tomorrow, what stocks moved and why, and where the volume is at, can throw up trading opportunities.
Forcing yourself to write down the key themes can or are likely going to affect the market and asking yourself what it means in terms of your own positions can save you a lot of money.
I can honestly say that my performance began to remarkably improve once I took a more serious and methodical approach to trading. In times like this, when traders with no exit plans are now grimly holding on to “investments”, one can easily outperform the market just by having a simple stop loss.
Stop losses should not be scoffed at
Many people disagree on stop losses. With a good broker, your stop loss won’t be in the market – but it will be acted on when that level hits.
If you trade via a spread bet firm such as IG, then your stop loss won’t be in the market either. But market makers know where stops are likely to be, and so it pays to think about this.
Anyone placing their stop on the support line is asking to be stopped out. The key is to place it in the support zone, but not too close. It’s a tricky conundrum indeed.
The beauty of stop losses – either physical or mental – is that once they are hit there isn’t any indecision. It’s a case of following your plan. If you question the stop, then you’re having an argument with yourself. And how dumb is that!
Stop losses should be used, whether these are physical or mental, but if they are mental then make sure you have a reliable alert service in order to get you out of the market.
Nothing is worse than missing a level only to realise you now have to close a position that has moved a lot further than your intended exit price.
- Constant vigilance and awareness of the market is the only way to defeat complacency
- A trading journal will force you to think about your trades and positions on a daily basis
- Stop losses can be gunned down by other market participants but better to be stopped out in a shake than run a loser
You can download Michael’s trading handbook from his website at www.shiftingshares.com
This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.