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Resident trader
Learn from your losing trades
Will Kraa, July 29, 2007
Last week I wrote about a trade where the market got very excited about VCR so that prices rocketed up and then collapsed. I managed to get out with a good profit when it became obvious to me that things were out of control and it was time to exit. Today I will look at a similar trade which I did not manage so well.
It was right at the beginning of my experience of trading CFDs when I had decided to set up an account with a modest amount of money and see what I could achieve. I did quite well and this trade helped with a good profit but it could have been better if I had done what I should have done.
The stock that attracted my attention was Paperlinx Ltd (PPX) as it had fallen quickly from a preriod of sideways trading at just over $5.00 and then found support at about $4.45. Three times in late May to early June it fell to the support level and then rose again so when it started upward again on 10 July I decided to place a trade with my stop near the support level at $4.40. I was able to enter at $4.56 (first arrow on chart 1 below) for a risk per share of 16 cents.
With this risk per share a contract for 10,000 represented a risk for the trade of $1,600 which was a suitable amount of risk for this account at that time. My initial stop loss was at the support line and the 15 day exponential moving average (EMA) was to be the stop to take profits. The trade opening was followed by a very good rally in price until 6 August when there was a pause in the uptrend and I decided to exit at $4.98 for a profit of $4,200 (second arrow on chart 2 below).
It would seem that this was a good trade and I certainly made a good profit of about 2.5 times the initial risk. But it is obvious from the chart that the stock was still trading well above the EMA so my profit taking stop was not hit and except for the desire to lock in a profit there was no real reason to get out at this stage. So even though it was a profitable trade it was not a successful trade in that I did not adhere strictly to my trading plan for this trade.
Over the next few days it became apparent that this rally was not over yet and so I realised my mistake and got in again at $5.09 on 18 August (first red arrow on chart 2). This meant I was over $1,000 worse off than if I had stayed with the trade. My stop loss now was at $4.93 as shown by the second support line for a risk of 16 cents per share as before and I could again open a contract for 10,000 for a trade risk of $1,600.
This time prices traded sideways for a while and even briefly moved below the EMA but did not get anywhere near my initial stop for this trade. Then it again rose steeply until there was another sideways move in early October. I did not lose my nerve this time and continued to hold since the EMA was not breached.
Then another steep rise culminated in the large white candle on Friday 19 September. On that day we had visitors and had planned a trip to the Sunshine Coast but I had a feeling that prices might rise to an unrealistic high. It was just a kind of gut feeling so I took my laptop to see if I could find someplace to connect to get online and see what was happening. I was unable to do this and that evening the chart showed that there was indeed an all-time high this day, way above what might be expected for the stock (which does not have all that much going for it anyway). This was another occasion when prices had gone up to an unrealistic point but circumstances had prevented me from harvesting the profit from this extreme move. My feeling was that on Monday there would be a drop in price and that is exactly what happened.
The price had made a new high (never surpassed for this stock before or since) and had done so in what was likely to be an unsustainable manner. This was different to the way things had gone during the previous trade when there was no real reason to get out. On Monday prices fell below the previous alltime high of $5.71 (which was on 21 February 2002) and it was plain that the move was not likely to continue. This seemed another one of those times when the market had been overcome by a wave of emotion to push prices to unrealistic highs for this stock. There was no good news that might have provided a reason for the move.
I should have locked in the profit right then but as the price dropped I felt disappointed and did nothing. In fact I did not even get out when the price dropped below the EMA as it did on 25 September and I held for a few more days hoping for another spike in price to recover the potential profit I had not locked in.
By 1 October it became plain there was little chance of such a thing happening as the stock continued to trade below the EMA. I then decided to get out at $5.40 for a profit of $3,100 for this trade. This was just as well as the price soon declined very quickly. If I had continued to hang on for another rally I would have lost all the profit for this trade.
As far as my performance in this trade is concerned, yes I had made profits but I had not followed my plan in either trade, getting out too early for the first one and too late for the second one. This is not good trading so these profitable trades were actually losers. I had not lost against the market but I am not trading against the market but against my own tendencies to allow emotion to run the trade. I had lost in the battle to follow the plan and as a result had missed out on extra profits that were there to take.
Even if I had not got out when the market made its unsustainable upward spike, I should have got out when it crossed the EMA. This would have saved me from losing an extra 7 or 8 cents profit. Also this should have been a single trade with an entry at $4.56 and an exit at about $5.47 for an overall profit of $9,100. Instead of that the total profit was $7,300 so I lost out on $1,800. Fortunately the trades were done with Deal for Free so there was no extra commission to take into account.
Alternatively if I had been home that day I would have got out at somewhere closer to the high since that is what I was anticipating would happen. I well remember as we were traveling with our relatives hoping to find an opportunity to see what was happening to the trade. What I should have done of course is set a profit stop to get out automatically if prices reached a certain level. That I did not do this is possibly due to the desire to get as much profit as possible in case the price went above the level I might have set to take profit.
The use of this discretionary stop in this trade would have allowed me to collect somewhere around $3,000 extra profit. I could have done that on the following trading day but did not and again this was no doubt due to feelings rather than rational thinking. After all to take the trade then would have meant losing out on some of the profit available before. Psychologically it is hard to be content to lose out on what might have been but in trading such feelings and desires have no place.
There are trading systems which have an inbuilt profit taker to capture the profit available from such extreme moves but on the whole these do not seem to work well, often getting out of trades which continue to do well. It is therefore more of a discretionary stop which can be used if you have had a lot of experience in the market. Otherwise it will on the whole be better to stick to the trailing stop even when these events take place.
The difference between doing what I did and what I should have done might not seem large but it is these small differences that can add up to a large difference in the end results. Also I left myself needlessly exposed to a fickle market at the end of the second trade and was lucky it traded sideways for a while before the big drop.
It pays therefore to review your trades and see where you could have done better. It is part of good trading to learn from your mistakes and to avoid repeating them endlessly. You might remember from an earlier discussion where I mentioned the outcomes from procedures in medical clinics where it was those who reviewed their procedures and performance who had superior outcomes. It is the same with trading.
The other lesson from this trade is what I keep on saying and what every successful trader will tell you: that it is necessary to trade strictly according to the rules you have set for the trade. I allowed my feelings to get in the way of good trading. The less you do that and the more you stick to the rules for the trade the better your end results will be in spite of the occasions where ignoring the rules might get you a bigger profit.
Fortunately in this trade I did realise my mistakes in time and so avoided disaster. I did not get out as soon as my stop was breached but did do it a couple of days later. Not to have done so and waiting a bit longer would have wiped out all the profit for the trade. Just look that at big black candle soon after I exited. So if you have done the wrong thing admit your mistake and rectify it, don’t just hang on hoping for a better outcome.
Explanation:
Using the 15 day EMA as a trailing stop is one way of ensuring profits are not allowed to disappear after a trend is over. It is not possible to get out at the top of a trend since at that stage the trend is still in place. When a stop is triggered this does not guarantee that the trend is finished. Even if the price has fallen below the EMA as there is always the possibility that the upward trend may resume but some rule to get out has to be used to protect profits.
In trading we are not dealing with predictions or certainties but with probabilities. If prices fall below the EMA it is probable that the trend is finished and it is necessary to act accordingly by exiting the trade.
The way I do this is by waiting for the close of trading to see if the price is below the EMA. The next day I exit unless by that time the price is again above the EMA and then I will wait till I see what happens just before the close and if by that time it is again below the EMA it is time to get out.
Using the EMA as a trailing stop illustrates how even simple indicators can be used to get good results. Simplicity in trading rules is desirable and having multitudes of indicators does not improve trading.
Fundamentals:
It is interesting to reflect on the reasons that might have produced these moves. Paperlinx at the time had made an acquisition overseas and had run its business well with consistent small improvements in profits. It is possible that people thought the overseas business acquisition was going to do wonders for profits but the chairman’s message to shareholders released at the time showed that the profits had been made in a very difficult business environment. In fact this is not the kind of business that is likely to do anything spectacular to justify this share price performance and as people began to understand that great increases in profits were not on the menu the mood changed and prices rapidly retreated.
More articles from tis week's newsletter
International investing: Chinese whispers
Commodities: Uranium & iron ore on fire
Commodities: Which is the most popular to trade?
US plunge: Markets around the world are marching in lock step
Super: Young savers need to rethink super
Shares: Why technical analysis matters
Stock of the week: ADO
Warrants: Instalment pricing explained
Shares: Chief ratios for stock hunters
Shares: Earnings yield an omen of doom?
Super: The Y2K of super in 2007
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