Your Most Dangerous Trade

Do you still have days when you are 100% sure about a trade. You just can’t lose, the stock that is dropping was a real buy and it has already fallen a great deal so it could not possibly fall any farther. Can it? So you wait and then plunge in, you can’t lose so why not just go big? You want to buy in and sit back with dreams of what you will do when the stock rises back up to its past glorious price high. You have almost spent the money in your mind when the weirdest thing  can happen, the stock can continue going down even farther after you buy it. But you are not concerned the stock was an excellent company so it will get back to its highs, you just have to be patient. The next day it could drop even more, okay so you will just buy more and feel good about your dollar cost averaging. You imagine a drop in price will just be another opportunity, you believe you will be the next Warren Buffett buying value. You pat yourself on the back and wait. But it  may keep falling, you will start to fell the heat, your account will be  much lower than when you started on this ‘can’t lose’ dip buy into the abyss. You reason “It is only a paper loss, I still own the stock as long as I do not sell it I still can wait for it to go back up.”

This story never ends well. What traders don’t realize is that either the P/E was contracting because the future growth in the company no longer met analysts expectations so it was being distributed by institutions not bought. Or the market was entering into a bear stage and stocks were being sold off to raise capital for cash withdrawals from mutual funds by smart investors selling their mutual fund shares. Or the stock simply peaked out and had gone as far as it could with everyone owning it and no buyers really left to come in and push it higher.

What ever the reason this is why you always must have an exit plan and the price that it needs to go to that will mean you were wrong and it is time to sell. Many times the more obvious a trade looks the worse the odds of it being a winner. Most the time the hardest trades to take are the ones that are the winners. The sad thing is while the knife catching trader is losing his account and sitting in a puddle of sweat having been stressed out and losing money there is some mellow rich trader who shorted the same stock and is out by the pool with a drink and a cigar counting his winnings.

Whether buying a dip or buying a breakout any trade can be a losing trade. You must mange position size and have a stop loss regardless of your confidence in your trade entry. The worst trades will at times seem like the no brainer. A stock that has fallen 25% can fall another 50% it happens all the time. A stock that has doubled can double again. The key is to not get on the wrong side of a trend and stay there due to overconfidence.

Always remember: Your most dangerous trade is the one that you think you can’t lose. It makes you trade too big, be overconfident, sloppy, greedy, and not use stops.