Market Myths Exploded
( A series of articles exposing common misconceptions about investing and trading)
Myth # 1 — Always double down on paper losses to recapture them
By Michael C. Thomsett, contributing writer, SmartStops.net
A good chess player knows that losing an important piece is a critical moment in the game. The novice will plow forward aggressively, hoping to even the score and exacting revenge on the opponent. If they are playing against a more experienced player, this tactic almost always loses.
You can learn a lot about the market if you understand the strategies of chess. So what should you do when positions in your portfolio are below your basis? These notorious paper losses are troubling, especially if you have sold off profitable positions to take profits when you could. This means you end up with a portfolio full of losers, something no one wants. A paper loss is a loss, but it makes no sense to hold and wait without knowing why your position declined.
To the novice trader, it might seem sensible to buy more shares of the same stock. The theory behind this requires some basic math. For example, if you buy 100 shares at $50 and it is now worth $42, you’re down $800. It takes eight points to get back to your starting point. But if you buy another 100 shares, your average basis is $46 per share:
($42 + 50) ÷ 2 = $46
This means you only need a four-point rise in the stock to break even. You have cut your deficit in half. It seems like a smart move, right?
Not necessarily. Even seasoned traders and investors can call into the trap of chasing good money with bad, the premise behind the theory of averaging down. This might work in situations when the stock price has simply followed a broader market trend, and is likely to rebound along with the rest of the market. But what if the price decline was caused by something more specific to that company?
Before putting more money into the attempt to recapture paper losses, ask yourself these questions:
1. Do I really want more shares of this company? If so, why?
2. What is the underlying cause of the price decline? Was there a fundamental weakness or decline I should investigate? Does this mean that the stock simply might not come back at all?
3. Am I better off selling this stock and buying shares of a different company? (watch for another article in this series about the fallacy of holding on for the benefits of the long-term capital gain)
It is difficult to just walk away from losses. With this in mind, use stop orders to minimize losses. Or if you can’t let the trigger be pulled for you automatically, rely on risk alertsso your decision-making process can be triggered into action when risk has entered your position. You’re better off living with a small loss than hoping for a rebound that might never come. Stubborn traders lose, and wise traders know when to accept a small defeat. its been proven you can only win less than 50% of the time,and make decent profits so long as you let winners run and cut your losses.”
An alternative strategy: take small losses and replace positions with intermediate-term and relatively cheap long calls. The cost is minimal and even though the odds are not great, you might recapture your loss through option profits if the timing is right. Meanwhile, reinvest your funds somewhere else and apply wise technical and fundamental tests beforehand.
Paper losses can destroy your overall return by tying up capital while you wait for a position to turn profitable. That lost opportunity is far more destructive than just taking the loss. You can view opportunity costs and how much your money is making per day in the market for you at SmartStops.net