Sunday, May 25, 2008

Lost and Found, or Does Common Sense Work in Trading?

There are things in trading that run contrary to common sense as we know it. Recent conversation with a trader who asked for advice is a good example of such occurence and illustrates often-made mistake.

First, a joke showing what common sense leads us to do. Fair warning: joke is silly and decisively not funny. A drunk crawls under the street light looking for something on the ground. Asked what he is looking for he says "Lost my watch on that corner". Asked why he is looking here when a watch is dropped 15 yards from the spot, he explains "It's dark over there, little chance to find anything, so I am looking here where there is a street light".

... OK, I warned it was lacking in laughter department. Nonetheless, it indicates that looking for a lost thing in a well-lit spot instead of where the loss has occured is silly. Now, let's get back to our trader and his question.

- I have this pattern of suffering a string losses... it starts usually when I get onto some very volatile stock or a stock making unusually big movement, looking so lucrative because of a great potential. So I jump in, it moves against me, I take quite a loss. Next thing I know, I make trade after trade on this same stock. It's like I got addicted to it and just can't move onto something else. Loss after loss, the day turns into total disaster. Got something to hit me with to cure this disease?

- Got a question for you. Why continue trading that same stock after couple tries proved unsuccessful? Why not leave it be and move to something ou have firmer grip on?

- Well... it makes big movements, I have better chance to get back all those unusually big losses...

- But you don't have reliable read on this particular one. Isn't it more likely that you will suffer more "unusually big losses"?

- Ummmm. I don't know. I just feel it's natural to stay with it until I get my money back. Hasn't happened yet, even once.

That's when I remembered that joke. It's a common sense and natural thing to do in every day's life to look for a lost something at the spot where you lost it. In trading, not so much. Go to well-lit spot and look to get your money back there. Lost money is not tied to a particular spot (stock), it's lost in the market. The market is a big space; go where there is a streetlight that helps you read things well. A stock that you have no read on is to be left alone. You have no personal relationship with it, you don't need to get revenge; it has no idea about you and it's not after you. Free yourself from things that don't work. Focus on what does.
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