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Managing a Losing Trade


There is more than one way to look at every situation. My individual perception may be different from yours. Part of the time there may be room for interpretation because the ‘facts’ are soft and may be considered from different points of view. At other times, the facts are undisputed, but people have different interpretations. Here is one example.

Do you have a loss?

 

Let’s look at a simple situation. You invested $10,000 in the stock market. Today you can sell those positions and collect $7,000.

 

Question: Did you lose $3,000?

 

I find it quite surprising that many people believe that they did lose money while a segment of the population believes there is no loss yet.

 

Yes, there has been a loss

 

Here’s how I look at it:

  • The market values this item at $7,000.
  • If the account is with a broker, you may only borrow money based on that $7,000 valuation. Your belief that the stock in your account is worth $10,000 is imaginary.
  • If you receive a margin call (based on a loss on a different investment), your broker will show no tolerance for your argument that the account is really worth $10,000 and that it’s not fair to value it at $7,000.
  • If you want to withdraw cash from your account, your broker will not allow you to take more than $7,000 (assuming 50% margin), even though you believe they should let you take $10,000.
  • If this were a house and not stock, your bank would not give you a $10,000 mortgage based on your estimated valuation. They would base the loan on a $7,000 valuation.

 

Pretty much the whole world recognizes that an investment may have been worth $10,000 at one time but that $3,000 has been lost and the current value is only $7,000.

 

No, there is no loss (yet)

 

The argument in support of believing there is no loss is this:

  • If I don’t sell my asset, I cannot have a loss.
  • A loss only occurs after I exit the trade and have no chance to recover

The large group of people who accept those arguments do not recognize reality. This is important to us because it affects how we think — and thus, how we act.

 

Almost all traders accept the truth that managing risk is an essential part of being a successful trader. Those traders also share the opinion that it is unacceptable to incur a large loss and that it is necessary to take some defensive action when a position is losing money and has become too risky to hold. That defensive action is (more often than not) to exit the trade, take the loss, and move on to another trade when the time is right.

 

However, people who believe that they have no loss currently (even though they may admit to being at risk of losing money) may stubbornly refuse to take defensive action. If they believe that closing the position is the act that creates the loss then they will hold onto risky positions, hoping that the loss will disappear. The reason this is a very poor way of thinking is that they tend to hold bad positions when successful traders understand the importance of getting put of losing trades (accepting the fact that the money has already been lost) and reinvest (at the proper time) the money into a better (less risky, more chance to earn a profit) trade.

 

The innocent-sounding mindset that has people believing that a loss is not a loss until it becomes realized (i.e., position closed) keeps them locked into less than satisfactory positions. And that cannot be good for long-term results. Then there is this point: If the position does recover and the $3,000 loss disappears, they feel vindicated and ignore the fact that other positions would have earned double or triple that $3,000 over the same time period.

 

Rethink your position if you believe that a losing trade has not yet ‘lost’ money.

 

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