Making Sausage
Ninety-nine percent of this game is fifty percent mental.
Yogi Berra
Every time I take a sizable drawdown, I ask “Why?”. Reasons vary, but there is one mistake I am prone to make again and again. Plunging.
Plunge: To enter quickly and forcibly; to pitch or throw oneself violently forward, hence, to act with reckless haste. Act or instance of engaging in heavy and reckless speculation.
I am, by nature, a positive person. A promising trade sparks my enthusiasm, and that often prompts me to trade too large on my first commitment. What I have come to understand, however, is that the initial trade is always the riskiest. The trader’s entry into a new opportunity is like seed money placed in a new venture. Promising but as yet unproved. The careful venture capitalist will add to his position only once the venture begins to prove itself by reaching benchmarks along the way to success. How is it any different for the trader?
Ironically, betting too heavily early on has taken me out of some trades that would have proved very profitable. It works like this: first, I spot a promising trade. Next, fired by enthusiasm over my discovery, I take a strong position. Once the trade is on, I begin to monitor developments closely. At this point, with a new and as yet unproved position on the line, I want to cut losses quickly if the market begins to go against me. If the position does not produce an almost immediate profit, I begin to worry the trade. Perhaps I did not wait for the “psychological moment” to enter. Perhaps there will be a final shake-out before the move begins. Perhaps I am just wrong. I cannot take my eye off the trade. Why? Because my position is too large given the initial uncertainty that attends any new position. As a result, I am likely to relieve that tension at the first opportunity by exiting the trade. Likely as not, I have just given up a trade that would have, with a bit of patience, proved profitable.
And here’s the kicker, the psychological coup de grace: because I know that my losses are larger than they should be, I become disgusted and give up on the trade. And so the error is compounded. Not only am I likely to take a loss which is too large (because my position is too large), but I am also likely to miss out on the profit which I expected all along. For the trader, this is the worst of all possible worlds.
How can one correct this error?
In order to take my medicine, I have to own up to my limitations. Taking on a large position before it has proved itself makes me nervous. I can tell that I’m nervous about the trade, because I cannot stay away from the monitor. I watch each tick for confirmation that I am right or for an indication that I am wrong. I may have confidence in the trade, but not enough to carry the size I have. When this happens, the best and easiest remedy is simply to cut back. Once I become aware that I am worrying the trade, I reduce my position at the market. If I continue to worry, I cut down again until I am comfortable.
In order to be able consistently to start small in a new position, it’s important to understand the role, or function, of the first trade. Think of that small initial step as only a test, a probe. Imagine that you are hiking in unfamiliar woods, and you come across an old bridge which spans a wild river below. Do you run onto the bridge? Or do you first step lightly to test the strength of the bridge? If that first step shows the bridge to be sound enough, you may venture another step, and so on until you have either crossed the bridge or come to the conclusion that the bridge is too shaky to cross. Either way, a decision to cross, or not, made in this manner is well-founded, conservative, and probably correct.
Just as you would not trust your full weight to an old bridge until you had tested it, you should not trust a new trade with much capital until it has proved itself by turning profitable. Start small. Add to a position only if earlier positions are profitable. Never average into a losing trade. Would you take another step if the bridge started to creak and sag under the weight of your first step?
Here’s the general rule: begin each new position with too little capital. If you’re going to make a mistake, it’s best to make it on the side of conservatism. One benefit of starting too small is that pulling the trigger on a trade is much easier. If you have done your homework and have come to the conclusion that a position is reasonable, then removing psychological impediments to taking an initial position is a good thing. Starting too small helps overcome hesitation and gets you on your way into the trade.
Do not expect that getting the first position right will be easy. Often, the initial probe does not work out. Let’s say that you think XYZ will rise substantially. You wait for a setup on a pullback before taking a first, small position. Over the next few hours or days, the stock continues to churn without resolution. Then comes a wave of selling which takes the price to a new interim low. You close your small position, take a small loss, and wait for a better opportunity. The stock begins to rally from its low, showing signs that bidders are finally willing to move the stock higher. Again, you take a small first position, and, again, you monitor the stock closely. But buying dissipates, and the stock begins to drift. As the stock ticks to a new low, you exit again even though you suspect that a bear-trap is in the making. If the trap closes, you are ready to probe the market again with a new position, but if not, you are safe on the sidelines. As you expected, the new low proves to be a trap. Price rallies strongly off of its lows, and once again you take a small position. This time the position is immediately profitable. You add to your position and resolve to add again once near-term resistance is overcome.
Patient probing and a few small losses are required before you get it right. Here’s what George Segal says in The Outer Game of Trading:
I’m willing to probe a market as many times as it takes. That’s a unique concept to most people. Most people get shut out by the market because they tried it once or tried it twice. Usually they just give up at that point. That’s a fairly rare quality, to keep coming back, to keep knocking on the door until it opens.
If testing the market until the door opens becomes too expensive, you’re very likely to quit trying too soon. The best way to knock is to trade small. If you believe in the trade, keep trying until you get it right. This process is not particularly neat or pretty–a little like making sausage. But the ultimate result can be very tasty.
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