Saturday, February 09, 2008

Things That Are Important to Traders - Part I - Can a Good Trade Result in a Loss?

My guess is that most traders would say that making money is the most important thing to them in their trading. Naturally, that is the ultimate goal of all traders and investors, but there certainly are many other things that are extremely important yet may be overlooked in the quest for the ultimate goal.

Let me offer this thought for your consideration: the most important thing for a trader is to make good trades and not every good trade makes a profit. How could a trade be good yet not be profitable? Let's take a look at an example of a trade that a hypothetical investor may have made using some real numbers. On December 10th, after hitting a resistance on the 9th, Mcdonald's Corp (MCD) gapped up at the open and stayed well above the previous day's close on higher volume, all of which could have been interpreted as bullish. Suppose our hypothetical investor bought the stock at the close that day of the gap (12/10/07) for $61.90. The following day, the stock moved up again on even stronger volume to close at $63.13. The trade looked pretty good at that point, but the following day, after opening up, MCD fell to close at $61.66. From there it continued to fall into January when it got into the low $50s. In looking at the chart, there had been support around $60 so it seems like an exit on the break below support may have been a good decision. In that case, the investor may have lost $1.90 a share, but isn't that better than hanging on for another $10 a share drop. In that instance, the trader could have taken the loss (cut your losses) and if he still liked the stock, waited until it formed another support and re-entered. In fact, the stock made a double bottom toward the end of January and our hypothetical trader could then have re-entered around $51. As I write (2/5/08), the stock is near $54. By cutting the loss, the trader would have initially lost $1.90 and with re-entry on a bounce off new support, would now be up $3.00 on the new entry. Which is better -- being up $1.10 overall or down $7.90.

I understand I will hear the argument that this is Mcdonalds (MCD), "it'll come back." It may. Of course, the same argument was made with Enron. GE reached over $60 a share in 2000. It now trades in the $30's. When is it coming back? CSCO was over $69 in 2000; it is now in the mid $20's. When will it come back? Only you can answer the question whether it would be better to take the early loss and whether taking that loss makes for a good trade. Personally, I prefer to make the good trade, even if it results in a small loss, so I can move my money into another position that is going my way rather than holding on for dear life as a stock plummets and hoping or praying it does come back. Sometimes, they just don't come back and even if they do, how long do you want to wait just to hope to get back to even? It is important to remember that in order to just break even on a stock that drops 50%, it must move up 100%.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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To comment on Bill's article click on the "comments" link below.


Sam said...

Outstanding thoughts. Why don't people learn? You are a great teacher and your students should listen.
It is always nice to be able to come back in tomorrow.

Keep Smiling, Sam Stote

Anonymous said...

This is what I need to hear. I shouldn't be sitting on these loser stocks and I'm going to start cutting my losses. Thanks for the concrete example.

Bill Kraft, said...

Thanks, Sam. I sincerely appreciate your kind words.
Bill Kraft

theundertaker said...

I think you are the first pundit recently calling attention to % loss vs % gain. I created an excel table to remind me that a loss of 10% requires a gain of 11.11% to break even on the turn. Correspondingly down 20% requires an uptick of 25% to BE, 30% requires the uptake to be 42.857% to BE, 40% down, 66.667% up, 50% down requires 100% up as you remind us. Obviously this progression is not linear and probably 10% stop losses have been historically popular. 20% down is not too bad, but you can see at 30% you are asking a great deal of the market and the math to get you feeling better.
Bill Hoevet

Ed & Jeanette said...

Thanks for the reminder article. If the trader was hesitant to exit, "just below support," at least he could have set a stop that would have automatically prevented much further loss. Perhaps another reminder about the, "Wash Rule," should be mentioned when talking about re-buying the same stock, after a loss, on a new up-move. A waiting period of 30 calendar days after a loss sale is required, otherwise a tax deduction will be disallowed.

Bill Kraft, said...

Glad to hear it, Anonymous. It is extremely important to include an exit strategy (for both losers and winners) in your business plan. I discuss the creation of personal plans in depth in my book "Trade Your Way to Wealth." One of the major keys is creating the exit plan before ever entering the position and then following the plan. As far as I can determine, that is one of the best ways to take the emotion out of our trading. Thanks for writing.
Bill Kraft

Bill Kraft, said...

Bill, thanks for adding the important math about how much of a gain is needed to make up for varying percentages of loss. I believe it is important information about which serious traders should be aware.
Bill Kraft

Bill Kraft, said...

Ed & Jeanette,
Excellent point. I will do that in a later article. I've already sent the article for next weekend to the publisher since I'll be heading for New York and Traders Expo later this week.
Bill Kraft