Recently I have been hearing a lot of stories about traders who blew up their accounts. Many of these traders have been successful full-time traders trading for many years and even decades.
Most of the stories go like this:
- A first mistake was made with a rule violation
- Holding a position overnight (for an intraday trader)
- Holding open positions when going on a holiday
- Having a strong directional bias and entering a trade on that bias while ignoring or rationalizing away the contradictory price action.
- Having an oversized / overleveraged position, being overly confident of the trade.
- Not putting a stop, being overconfident on the direction of the trade.
- As a result of a the first mistake, a sudden big loss was suffered on the position
- This is usually due to major events, e.g. tsunami, central bank policy meeting decisions, huge overnight gap due to a market crash, unexpected company news
- Instead of cutting and analyzing the situation from a state of calm, the trader reacts by either doubling down or reversing + doubling up.
- When faced with a small loss, experienced traders would be able to easily cut the loss.
- However when faced with a huge loss, experienced traders revert back to being a retail trader. Worse still, their trading success makes them confident of being able to trade their way out of the position by doubling down or reversing + doubling up, and that confidence makes them think that they _cannot_ be losing this huge amount of money. They might think back on their past experiences where they have doubled down or reversed + doubled up, and traded out of bad situations many times before, and think that they can do it again (not realizing at that moment how lucky they were previously).
- Down the slippery slope
- Once you start doubling down, you can’t stop.
- Since the initial loss was large in the first place, your account size does not allow you many chances to double down. Usually 3 strikes and you are out.
- And for those that reversed and doubled up, the market whips wildly up and down, and the trader ends up buying at the top of a swing and selling at the bottom of a swing, while the losses compound with the doubling of size each time.
- Account wiped out
- This usually happens in the matter of a few hours.
Roy L. Longstreet, a famous soybean trader in the past, had a quote: “The first mistake teaches — the second mistake kills.”.
I would say that the first mistake was the one that indirectly killed them. It was the first mistake that opened up the huge loss, that led to them sliding the slippery slope. Successful trading is a lot to do with not making mistakes.
These stories are tales of caution. Traders don’t experience huge losses all the time. We are accustomed to small losses and repeated practice has allowed us to handle those well, both psychologically as well as taking the right actions based on our trading plan.
A sudden huge loss however is something that traders don’t get enough practice on (which is both good and bad!). Hence when faced with a sudden huge loss, your emotional mind (limbic system) takes over and your logical mind (prefrontal cortex) gets thrown out the window.
These tales tell us that when faced with a sudden huge loss, cut your loss immediately! Then analyze what is the best action to take at that point in time, based on the price action, without the psychological burden of being in a huge losing position. You NEED to decide your next move from a position of ‘safety’, having a calm state of mind so that you have clarity of thought. To stress again, when you have a sudden big loss, CUT and THINK! Do not react!
It is better to be able to fight another day, than to lose all your bullets and be forced to quit the game.
Your trading plan needs to put in place interventions that would help to prevent such an episode from happening. There are two intervention opportunities:
- If one follows their trading plan, the first big loss should not happen in the first place.
- Nonetheless, even experienced traders violate their trading plans. Where you detect that you are in trouble, and that your limbic system has hijacked your mind, is when your losses hit your day stop. That is your big warning signal that blinks and tells you that you have to STOP! You might also put in two levels of day stop, one where you are forced to reduce size, and another where you are forced to stop trading for the day.