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Compounding Risk and Damage Control
Our article this week focuses on a common issue that falls under the Risk Management Department (as opposed to the "Technical Analysis" Department). Over the course of the last 10 years, I have been privileged to be in constant contact with all kinds of professional, independent traders. Once in a while, a trader might come to me for advice on a position that has gone wrong. Usually, it has gone REALLY wrong – that's why they are looking to other traders for advice. What to do? Well, first of all, I am not licensed to give investment advice (that expired a long time ago!), but I do draw and share my very own experience in having been in positions that have gone wrong on me in the past, particularly those where I have lost complete control, much earlier in my trading career, as well as those I have been able to manage unscathed, just enough to fight another day.
There are many different variations of "bad" positions, but a few things are common among these. Let's study them, so as to define the "how-to" in losing big! In so doing, we learn "how-not-to". There are really only a couple of simple steps that begin the path to getting into a bad position, that is, in professional speak, a situation of compounded risk:
The Conversion: the First Domino. For rookie Active-Traders, the problem of "converting" is extremely common. So what is it? Most rookies come in with a buy-and-hold mentality. This strategy, which is appropriate for Long-Term Investing, is commonly carried over into "Active Trading" where the strategy is specifically NOT to buy-and-hold. The main strategy there is to buy-and-SELL (and vice versa). "Conversion" refers to switching time frames in the middle of a trade. Taking a trade that is meant for a Day-trade or some very, very short time frame, and then "converting" it to a trade of a larger time frame. By converting in the middle of a trade, the trader is adding DURATION (time) to the trade… and in so doing they have just now assumed larger RISK. The rule of "Don't add to losers" does not just apply to adding more SHARES, but also adding more TIME. By adding Duration to the position, the trader has entered a path of compounding RISK. This is usually the first domino to fall in a cascading series of falling dominos – or compounded RISK - that is likely to end in a complete disaster.
The Average: the Second Domino, and beyond. Now that we know how to drop the first domino, the second, third and fourth dominos are usually characterized by the most dangerous, and that is not to add Duration (time) but to add exposure by increasing position SIZE – commonly referred to as "averaging-down." Once again, this is not just a "strategy" that has been promoted in the past for long-term holdings, but it is also one that is instinctive in every trader. Most of you are likely to be familiar with the instinctive impulse to add to positions and thus averaging-down a price entry, but in so doing you must acknowledge that this is yet another a step towards what is likely to end in a situation you do not like! Active Trading is risky enough, why compound it? We are in the business of mitigating risk, not compounding.
How not-to lose big begins with avoiding situations of compounded risk in the first place, and the signs are not very complex: these are usually made known by the UNPLANNED addition to exposure by increasing Duration and Size. Have you done that before? If you want to become truly a successful trader, you have to get that off your system.
Hope Mode or Damage Control. If a trade is going on for a lot longer than you had anticipated, if you have more shares than you originally planned, you must enter into a damage-control mode. Damage-Control means: REDUCE RISK!
As a trade goes bad, rookie traders are very susceptible to getting into "hope-mode." We are human beings and we are all born with such an automatic response. It is normal to "hope" that a position will return to a situation that is comfortable. But such an automatic (primitive) response is very detrimental to good trading. As I always like to say: Good traders are created, they are not born that way. A skilled trader has just as much skill in getting OUT of a bad position, as he or she has in getting IN and good one.
In the case of compounded risk, we must enter a state that is almost mechanical or robotic, with no ideas of romance or fantasy. In this case, we take control, as we always should. And particularly in a trade that has gone way beyond "what we originally wanted" we go into Damage Control mode by entering a state of RISK REDUCTION, rather than instinctive addition, or compounding. We have to resist the temptation to compound risk. I suppose they call this discipline.
Are you in compounded risk now? If you find yourself already, right now, in a situation of compounded risk – meaning, you have a position(s) that has gone way beyond your control – get into damage-control (risk-reduction) mode right now and do not waste any more time. A bad position is not just a financial burden, but also a psychological burden that will grip nearly every aspect of your judgment and decision-making, and cloud your vision. How can you see the markets with any clarity when it is blurred by a situation that is completely out of your control?
One of the first things I would do in this situation is take a portion of the position, close my eyes, and hit the SELL key, to eliminate some of the risk (or just BUY of course, for short-positions). This could be 20% or even 50% of the position. My task is to reduce risk, and as difficult as it would be, I'm just forcing the first domino fall into the OPPOSITE path, against compounding, and into reduction. That way, I can begin to think clearer and strategize my exit for the remainder of the position.
Time. In as much as it took to get into the bad situation, we must allow an appropriate amount of time to get out of it as well. Eliminating the whole position in one shot may be a good idea, but it may not be the BEST idea. If I took 20% off the table to initially reduce risk, I will allow plenty of time to get out of the remaining 80%. If I was in a bad Long position, I will use any rally as an opportunity to continue eliminating my position, all the way until I have removed it off my accounts. Eliminating bad positions from your accounts is like ridding your home of dirt, distractions or obstacles. It's actually a great feeling when you are done. You feel refreshed, new and now armed with a little more "confidence" that you can take control.
Take control of your trading, cut your teeth with your very own losses. In so doing, you turn what was a liability into an asset you will use to work your way steadily into the green side. The green side is not really that far away, you know, once you have realized that we are in the business of mitigating risk, and not compounding it.
Until next time, happy trading!
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Fernando now enters his 10th year
as an active trader, technical analyst and content contributor to the Active Trading
community and a long list of popular financial media. In 1999 he authored the
best-selling book