Chapter 3-3 Trading with Discipline

Below are two trading scenarios.  Scenario 1 is an example of why holding trades past a responsible exit price, though potentially profiting, is not a solid trading strategy.  Scenario 2 shows how dangerous and damaging a strategy of holding past a responsible exit can be.  In both Scenario 1 and 2, we put a reckless trader who has a bad habit of holding onto losing trades (Trader A), alongside a trader that adheres to his conservative exit strategy (Trader B).  When you breakdown the statistics, the results will prove why discipline is the key.

Scenario 1

Both Trader A and Trader B purchase 500 shares of the same stock at $40.55 as both see potential for the stock to rise to a price of $41.00, which is $0.45 away from their current entry point.  Upon entering both traders unfortunately find the stock reversing and quickly going the wrong direction.

Trader A chooses to recklessly hold the position past a responsible exit point that would adhere to a sensible 3 to 1 reward to risk ratio.  While Trader B gets stopped out of the position at his preset exit point of 12 cents, which is well within his minimum 3 to 1 reward to risk ratio.  As the stock continues its downward trend Trader A, who is holding onto this losing position, continues to watch his losses grow with every downtick.  The stock has now hit a level 40 cents down from the point in which he originally entered.  The good news is the level of support has held and reversed the trend back up.  Trader B noticing the support level that had formed reenters the position at a price of $40.20 for 500 shares as the stock begins another attempt at an up move.  This move proves to be a strong one as the stock manages to reach all the way up to a price of $40.75 before once again its changes trend and starts to fall down.  Trader A just happy to be up on the trade gladly exits the position at $40.70 feeling like the king of the world.  Trader B sees those same exit signals and too exits accordingly at $40.70, as the stock has reached well past his target price.

Trader A

Bought 500 shares of stock at $40.55 with an original price target of $41.00, and then decided to hold onto the losing position as the trade went against him.  He was at one point 40 cents out of the money in unrealized losses, before the stock fortunately turned and produced a 15 cent realized profit as he exited at $40.70.  Ultimately, Trader A dodged a major bullet as he risked a substantial amount to make only a very little.  Participating in trades like in this example, time and time again will surely whittle away your trading accounts as this is not a fruitful strategy.

Trade Summary for Trader A:

  • Bought at $40.55
  • Stock price steadily drops to $40.15
  • Down $0.40, but continues to hold
  • Price then rises to $40.70 and exits for a $0.15 gain from the original position

Trader B

Bought 500 shares originally at $40.55 displayed great discipline and stuck to his preset exit point of 12 cents, which did make sense since it definitely feel in-line with the 3 to 1 reward to risk minimum.  Trader B exited the position at $40.43, and was smart enough to continue to watch the price action of the stock to see if another opportunity presented itself, which it ultimately did as he reentered at $40.20 once a level of support was established.  Trader B then exited at $40.70 once the stock began to reverse.  Trader B practiced discipline and was rewarded for it by capturing a very profitable trade with very little exposure to risk.

Trade Summary for Trader B:

  • Bought at $40.55
  • Covers at $40.43 for a $0.12 loss
  • Stock drops to $40.15
  • Bought again at $40.20
  • Price rises to $40.70 and exits for a $0.50 gain from his second entry point

 

To recap on the profit and loss totals:

  • Trader A

500 shares x $0.15 = $75 gain

 

  • Trader B

500 shares x -$0.12 = $60 loss

500 shares x $0.50 = $250 gain

$250 – $60 = $190 gain

 

Which trader played the move correctly?

Obviously Trader B, not only because he gained more from the trade, but more importantly because he was able to keep his risk reasonably low while also being able to maximize his opportunity for gains.

Scenario 2

Both Trader A and Trader B purchase 500 shares of the same stock at $40.55 as both see potential for the stock to rise to a price of $41.00, which is $0.45 away from their current entry point.  Upon entering both traders unfortunately find the stock reversing and quickly going the wrong direction.

 

Trader A chooses to hold the position recklessly past any reasonable exit points, while Trader B stops out of the position at $40.43 with a 12 cent loss.  In this scenario, just like in the previous one, the stock finds a level of support at $40.15.  Trader B enters again into the position at $40.20 for 500 shares and sets an exit point 2 cents behind the level of support that is present at $40.15.  This time the stock fails to move back up and breaks the level of support, causing Trader B to exit once again this time with a 7 cent loss.  Trader A however, still is holding onto his original position hoping the stock will go back up.  The stock continues falling to $39.75 where it finds a new level of support.  Trader B once again buys 500 shares at $39.81 and places a stop loss exit once again 2 cents below the identified level of support.  The stock unfortunately continues its weak trend and goes through the level of support with ease, stopping out Trader B for the third time.  Trader A now having watch his position lose more and more money finally has had enough and too sells at the same point as Trader B at $39.73.

Trader A

Bought 500 shares of stock at $40.55 with an original price target of $41.00, and then decided to hold onto the losing position as the trade went against him.  Unfortunately for Trader A the stock never comes back up and his losses just grow.  He ultimately, gives up on the position and losses a substantial amount of money by not practicing any form of trading discipline.

Trade Summary:

  • Bought at $40.55
  • Stock drops to $39.73 and exits for a $0.82 loss

Trader B

Bought the stock 3 separate times ($40.55, $40.15, and $39.81) only to get stopped out each time for losses.  But he always stuck to the sound exit points he set, and by doing so, managed to keep his relatively losses small.

Trade Summary:

  • Bought at $40.55
  • Covers at $40.43 for a $.12 loss
  • Bought again at $40.15
  • Covers at $40.08 for a $.07 loss
  • Bought once more at $39.81
  • Covers at $39.73 for a $.08 loss

To recap on the profit and loss totals:

  • Trader A

500 shares x -$0.82 = $410 loss

  • Trader B

500 shares x -$0.12 = $60 loss

500 shares x -$0.07 = $35 loss

500 shares x -$0.08 = $40 loss

-$60 + -$35 + -$40 = $135 loss

 

Which trader played the move correctly?

Obviously, both Trader A and B incurred losses on their trades.  However, Trader B lost substantially less than Trader A even though Trader B was wrong 3 times on the stock.  More importantly Trader B was able to keep the losses fairly small by indentifying reasonable exit positions that fit his 3 to 1 reward to risk ratio.  Trader A, however, refused to accept the reasonable loss early on, and instead let his emotions dictate his trade, not the market.

Conclusion

As shown in both Scenario 1 and 2, simply holding is simply hoping.  Try to leave your emotions out of the trade.  Listen instead to what the market is displaying for you via prints, chart patterns, futures, sector, etc.  Always attempt to limit your risk as much as possible, while allowing yourself the opportunity to maximize your gains.  In other words, always keep your losses tight and let your winners run.  By utilizing a bare minimum 3 to 1 reward to risk ratio, you still have the same opportunities to maximize gains, however you will be able to prevent reckless losses.  To find consistent success in the markets it is essential to always trade with discipline.

Questions