This article could be subtitled ” Or… How to Avoid Losing Your Shirt in Today’s Equity Markets” and is the first in a many-part series on the many ‘Ways to Lose Money in the Stock and Commodities Markets’, (WTL). Some of the ways described in these articles will decrease your capital only in small increments. Some will help you leave additional profits on the table, while others will quickly delegate you to the ‘former trader’ pile of ‘has-beens’ and ‘used-to-be’s’.
More than likely, you will find some of your own experiences highlighted here several, perhaps many, times. If you don’t find yourself facing one of these challenges today, you will in the near future. Most traders will, in the course of their early trading lives, learn first hand about most, if not all, of the ways to lose before they learn how to win consistently. Your coach or mentor, if he/she is honest, will tell you his or her own horror stories. Remember, trading is a life-long learning process, easily understood but never fully mastered. There is always room for improvement. Even the best traders have bad days or off weeks. The key is to keep the losses small and learn from them. (If possible learn from the experience of others so you won’t have to pay for it with your own money.) Only then can you move on to increased consistency and greater profitability.
This Week’s Article:
Companies Can Go Bankrupt, What Do You Do If You Own Which Does
This is one of my favorite segments. It comes from personal experience. Early in January 2004, I bought a few hundred shares of Factory-2-U stores (FTUS). In mid-December after a several-day pullback, FTUS had a nasty gap down on nearly ten times average volume. The price wavered in a narrow range for a couple of weeks and then rallied above the base and pulled back into a buy setup on. This was my buy point. I was in at $1.20.
Planned as a potential multi-day trade, I questioned holding overnight with no upward movement. Being underwater overnight was new to me and the base formed over the next few days did little to help the feelings of unease. But, since the actual stop was not seriously threatened, I kept the position open. Even after a potential time stop, I held on, hoping for good news. (Amazing how emotions can sway judgment.)
The fateful day arrived. As always I set my hard stop right after the open and went about searching for entries on the day’s plays. About 10:30 I noticed a big red bar on my platform’s trade profit/loss tracking window. This was a surprise since the position had been so stable for so long. And besides, I had a hard stop (stop-limit order) in place. This would keep me out of trouble. Right? (Why do I hear laughter in the background?) No. Earlier in the day, (Aren’t we thankful for delayed news? In reality, all news is delayed, even the ‘Real-time’ news. More on that in another lesson.), the company announced a voluntary bankruptcy. Wham. The price went from $1.15 to $.40. This was a 67% loss in about 15 minutes. Only 8,000 of the 4,000,000+ shares were traded within my established stop-limit range during that 15-minute period. Needless to say I was not filled. To a fairly new trader, this was a BIG shock. I just stared at the chart for a several minutes, wondering if this was real.
Fortunately, I had a disaster plan in place. For morning gaps, it reads as follows:
Ø First. Do not panic. Easy to say, but hard to do. However, it will not be hard to do if a strategy is in place for these situations.
Ø Second, ignore the pre-market trading. From 8:00 until 9:30, ECN’s are doing most of the trading; some stocks don’t trade at all. If your stock is gapping down like this, it will be trading, but may be trading erratically.
Ø Third, when it opens officially at 9:30 EST, do nothing for at least five minutes. Just watch. After five minutes, mark off the low + the pivot point and put a stop for half the shares $.05-.10 under that low.
Ø Fourth, let it trade for 30 minutes. Then put a stop for the other half of the shares $.05-.10 under that 30-minute low. At this point, if the stock did not violate the five-minute low, all the shares will be in place, half with a stop under the five-minute low, half under the 30-minute low.
Ø On many occasions all the shares (or at least half) are still in play. Often, after a large gap, the opening half hour puts in the lows for the upcoming days. If the shares do stop, only a relatively small amount extra is at risk.
Ø From there, treat the play as a swing trade with a one-day trailing stop. The stock may rebound to prior levels. Follow the prior plan. For gapping up on a short position, use 5- and 30-minute highs as stops.
Since this massive downturn was very much like a morning gap, I used the low pivot point, $.40, as my new benchmark and set the hard stop a couple of cents under for the first half, .38 and .33 for the rest. The higher stop held and I still held all of the shares with a chance to recover some of the loss. At this point I realized I could either sell quickly at any point of recovery or take a longer term approach. In doing the latter, I had to accept the possibility of losing all of the residual value. This was my choice. In my mind I had already lost ALL of the money. This freed me to make objective decisions without regard for small gains or losses.
The next day trading bounced around the $.50 level for most of the day. A 25% increase in one day felt pretty good. The following Monday was a holiday, but while scanning for Tuesday’s plays I saw that several trades had triggered between $1.13 – 1.16. This was exciting. If this held at the open, I could get out very near breakeven.
The plot thickens. The next morning trading opened at $.47 AND the news feed reported FTUSQ (the new designation due to the bankruptcy) was going to be delisted from the NASDAQ and listed on the OTCBB on Thursday. I called my broker to see what that meant. Assured that I could still trade as needed, I formulated an expectation about trading over the next two days. First, if the price got anywhere near my breakeven point I was going to sell it all. If not, I expected to see the price drop dramatically on Wednesday morning as traders, like lemmings leaping off the cliff, tried to get out from under their shares. The price drop could easily violate my .38 and even my .33 hard stop.
Wednesday dawned. I awaited the results of my formulation. I did not set my hard stop. I was going to let the trade play out, even if it went to $0.00. In my mind all of the money was gone anyway, so whatever happened made no difference to either my financial account or emotional state. Down the price went, finally stopping at $.29, a loss of over 75% of my initial input. But for the rest of the day the price rallied, closing at $.51. Higher than the previous day’s close. Whew. Dodged that big bullet. I was now able to let the stock play out, still having the opportunity to recover some of the loss.
The next two days were very encouraging. The price continued to rally on very large volume. With the second day’s rally actually putting me in the money for about twenty minutes. A few trades went off above my original entry point. I was so encouraged, I didn’t sell at BE. For the next ten days or so, on much lower volume, the price fluctuated around $1.00. Still 15% below my entry, but much higher than the 75% below entry I had seen a few days before.
After a few days, the close was at my original entry price. The following two days had greatly increased volume and the price rallied to my first original target and more. I was able to sell half of my original shares at that target. The next day I sold at my second target and, due to the chart pattern, raised my final target to just below some overhead resistance. Unfortunately, the rally was not sustained and although the pullback was reasonable, the quarterly earnings report forced the sale before reaching the final target. After all of this, my gross profit was only $10 less than if the trade had progressed normally through the original targets. Quite a roller-coaster ride, indeed.
The morals of this story are three:
Ø First, have a disaster plan. Know it. Be ready to use it. Since you can’t predict even the next tick, you never know what will happen. Imagine your worst possible case and then add some to it and you’re about half way there. (And my big lesson, use stop-market orders for all hard stops on NASDAQ stocks.)
Ø Second, use what you know about crowd psychology to get you out or keep you in, as needed. This was how I stayed in when the price dropped completely through my stops. Without knowing it, this was my first experience with the idea of discretionary trading taught by RDFn.
Ø Third, learn to read the charts, listen to what they are saying to you, and use bar-by-bar analysis to anticipate the next movement. The rapid return to breakeven—with volume—kept me from selling too soon. Being patient allowed me to take a 75+% loss and turn it into a 15+% gain.