When we are trading a proven winning plan we know the odds are in our favor over the long-term, the market gives us our signal and we take it. But we know how odds work, we win some we lose some.
As most who follow me know I'm a breakout momentum trader. I take a position on a display of strength through the price action. Sometimes this works and sometimes it doesn't. When these breakout moves fail it's called a whipsaw. The market moves strongly in one direction only to turn on a dime in the opposite direction killing our trade thesis. As traders this is something we will always have to deal with. As legendary trader Ed Seykota has said, "if you want to avoid whipsaws quit trading".
Getting false signals is a big part of trading. How we deal with these unexpected reversals is a major factor that determines our long-term edge.
We discussed HAIN last week in our post. It had all the criteria of a strong
breakout entry. The move came on huge volume with a lot of upside Call option activity, and even Buyout chatter.
However Monday after the market closed HAIN announced a delay in the release of their quarterly earnings report due to "accounting irregularities".
As we know the market hates uncertainty. Following the announcement the stock dropped more than 25% on Tuesday triggering stops for a larger loss than anticipated.
While this drop was more than we had planned for, through proper position sizing we were able to keep losses mitigated so they were only modestly damaging.
A concept that is very important to understand is regardless of how confident we feel about the setup, anything can go wrong with a trade. For a stock to decline ~25% in one day is almost as bad as it can get. But had we not kept our discipline and maintained proper position size this loss could have been debilitating. Unexpected moves like this are precisely how most traders blow up their accounts. They feel so confident in either their ability and/or the current setup that they risk too much of their capital.
Prior to Tuesday's monster decline the stock was displaying very typical breakout behavior; there was little to hint at anything close to what played out. There simply is no way to anticipate this occurring with any real accuracy. Sure we could have avoided the trade due to earnings being announced soon or that the day after our entry the stock retested the breakout level putting us at an early loss. But these movements are quite common ahead of a news release or following a breakout. We account for risk to be elevated in how we size our holding and manage our expectations.
Ultimately we must stick to our plan and not let bias or greed influence our decision. As a general rule for swing trades (which this was) I will enter a partial position (risking .5% of total account equity) and only if the trade then moves in my favor will I add another .5% size. This means the maximum I will risk on any one trade is 1% of my total account. It is by being conservative and not attempting to get rich on any one trade that allows me to survive a shit-kicking like we experienced here.
Another important element to surviving in the market is to not let an initial loss turn into a disastrous loss. Just because the stock "fell too much" doesn't mean we should continue to hold the position thinking the damage is already done. This is exactly how traders can make a bad situation worse. Could the stock bounce back? Sure it could. But its also just as likely (maybe more so) that a real problem exists and this could just be the beginning of a 50% or greater rout.
The best thing to do once the trade thesis is invalidated is to GET OUT. I don't care if we only planned to lose 10% on the trade and we lost 30%. That doesn't matter one bit. Sure it sucks, but what if we hold and then it turns into a 60% loss? From my experience its much easier to make back our losses in a new strong entry signal than from a failed trade that we hope will recover.
For total disclosure we entered HAIN at $54.15 and placed our stop at $51.90. Since we had taken our initial .5% risk position size against the $2.25 stock price movement (~5%) and we exited at $39 (-25% move for the stock), our loss on the trade was -2.5% of total equity. While this is more than I prefer to lose on any one trade, because of the conservative position size damage was still relatively minimal.
The math supports moving into a new position rather than holding and hoping with the loser. Following the decline for HAIN it would require a 35% gain in the stock to get us back to even. If we entered a new position with similar risk parameters as the original trade it would require a 25% gain for the same profit. Although if we entered a new trade and it moved in our favor we would likely add another half position, requiring less of a move in the stock for more profit. For sake of discussion say we add another .5% risk after a +5% move for our new trade. This would then only require a ~10% further rally to get us to our +2.5% account gain. Basically if we can position ourselves in a new successful trade and pyramid the trade according to our plan of adding to winners, the gain needed from the new stock would be roughly half compared to holding the existing losing position and having it get back to even.
If you want to survive at trading and eventually thrive you must learn to take a loss when it comes. At least half of our trades will fail, if we can't keep those failed trade's losses to an absolute minimum the amount we make from our winners won't be enough to keep us profitable. When a trade shows a loss and invalidates our initial thesis we need to step aside, take the small loss, and find the next opportunity. Revenge trading, holding losers and fighting the market are what emotional unsuccessful traders do. To succeed we need to do the opposite. We must trade free of bias, cut losing trades when they invalidate our plans, and most importantly listen to the market and follow its direction.
While its always frustrating to get caught up in a losing trade, especially one of this magnitude, dealing with whipsaws is a big part of our process. The key to success is to keep position size on losing trades small to minimize risk and to cut the losing trades quickly once they invalidate our plan. If we can do that while adding to our winning trades we put the long-term odds greatly in our favor.
