Anatomy of a Losing Trade

James Kostohryz Jun 05, 2009 1:05 pm

It's my belief that trading and investing is, more than an intellectual discipline, an emotional discipline.

Therefore, I'm going to share the following self-analysis in the spirit of affecting positive change through financial
understanding.

Description of the Trade that Failed

After having correctly picked the bottom and having gotten fully invested on the long side in early March while the
S&P was between 680 and 700, on April 15, I announced on Buzz & Banter that I'd decided to take profits on my
entire long position. I did so with the S&P between 840 and 845.

I explained that I was expecting a dramatic increase in volatility accompanied by a correction of around 10%
sometime between April 15 and May 15.

I developed a 4-part rationale for a correction:

1. Given that it was highly likely there'd be disappointments at some point during earning season, the probabilities
of a correction were high. And given that companies that had recently exceeded expectations were being sold
after their earnings announcements, probabilities of such a correction had increased.

2. The prospect for speculation surrounding the stress tests was a looming threat to the market.

3. I developed a somewhat esoteric theory that drew an inverse parallel between the extreme volatility between
mid-October and mid-November of 2008 after a steep and steady fall, and what might be a similar explosion of
volatility after a similarly steep and steady rise leading up to mid-April of 2009.

4. Some proprietary indicators of mine that had a very good recent track record were flashing sell signals.

Notwithstanding all of these rationales, on the very day I sold all of my long exposure, I expressed a strong doubt
regarding my correction thesis: I do have one major concern: Everybody and their grandmother is expecting a
correction. So I very much doubt that it will occur in the manner that people expect.

On Friday, April 17, I actually decided to establish a put position in XLF and SPX in anticipation of a sharp 1- to 2-
day correction the following week. At the time I established these put positions, the S&P was at around 875.

The timing seemed perfect. The following Monday, April 20, the market corrected significantly to about the 832
level. As announced on the Buzz & Banter, I closed the put position Tuesday morning, April 21, when the market
was in the 835 range. So far so good.

I announced in Buzz & Banter that I was expecting another assault on the highs and possibly a false break of the
875 level before the market finally made a 10% correction. The former was spot on. However, at this point, things
started to go bad for this trade.

Beginning on April 23, I began to focus on risks related to the stress tests, and wrote an article on April 27 (Op-Ed:
Back-Door Nationalization?) highlighting the severe dangers inherent in SCAP. I began accumulating some put
positions in XLF on April 24 and continued through April 30, adding a VIX call position.

The timing seemed pretty good, as there appeared to be a false break and reversal on April 30. In addition, my
concerns regarding dilution due to SCAP were materialized.

However, there was no downside follow-through, and on Monday, May 4, the market gapped up above the
breakout range and hasn't looked back since.

I stuck with the trade through Friday, May 8. At this point, the options positions had lost more than 80% of their
value.

Even more painful than the loss of the option premiums was watching the stocks I was previously long rocket up
by 20%-plus or more on average. In some cases, stocks such as Bank of America (BAC), Yingli Green Energy
(YGE) and Hercules Offshore (HERO) were up by more than 70% with respect to the price I sold them at, on or
around April 15.

As I watched these stocks rocket up, I felt like a chump. Here I was, fundamentally correct about the countertrend
rally, (see Op-Ed: Is a Countertrend Rally Inevitable) and I was out of the market. Worse still, I was losing money
on bearish options positions.

Analysis: Where Did I Go Wrong?

It can be dangerous to analyze trades -- winning or losing -- after the fact, because hindsight is always 20/20.
However, I think that trying as hard as one can to analyze ones past trades -- especially the ones that didnt work
out -- is one of the best ways to become a better trader and investor.

When I go back and carefully review my thoughts and my published writings, it's clear that there were major cross
currents (not necessarily contradictions) in my thinking. On the one hand, I was hugely bullish regarding the
medium term. Fundamentals, flows, contrarian sentiment indicators, etc. I had laid out the bullish case in great
detail. On the other hand, I developed a solid and plausible short-term theory of a correction.

As I analyze it honestly and objectively, the arguments in favor of a correction were not, on balance, stronger than
the arguments for a continuation of the rally. Not only was there my medium-term case that I laid out in Op-Ed: Is
A Countertrend Rally Inevitable? there were important short-term considerations that I'd correctly identified - such
as strong inflows, and the fact that almost everybody was expecting a correction (which advised against assuming
a short position).

So why did I assign precedence to the short-term factors that favored a correction over the short- and medium-
term factors that favored a continuation of the rally?

Ultimately, I believe what biased my call for a correction was simply a general feeling that there must be some
sort of correction at some point; that a correction was overdue. This feeling, based on past experiences in
different circumstances, was probably exacerbated by a degree of anxiety caused by my wanting to protect the
massive gains I was sitting on. Thus, I subconsciously began to select data that relieved that anxiety.
I began to see risk points as potential triggers of the correction: 870 resistance level, earnings, stress tests, etc. I
even began observing weak signs of distribution and sector rotation, wondering if they were signals of a top.

Here's one of the keys to the problem: There's no such thing as a market being overdue for a correction. This is
pure nonsense. There's no reason why a market has to behave in a fashion that one is comfortable with. Past
experiences are only relevant to the extent that current circumstances are analogous. In this case, they weren't.
So leaning on past experience was a mistake.

Closely related to the above point, I made a mistake in assigning too much importance to conventional technical
analysis. Technical analysis is based on recognizing patterns that in the past have tended to repeat. Here's the
catch: Most of the observation points for patterns occur during normal times. The problem is, there's nothing
average or normal about the times we're living in. Thus, to expect past conventional patterns to repeat was a
basic mistake. To seek comfort in such patterns was a mistake, too.

Another problem was that I wanted to protect gains. This is natural. However, it's not a constructive emotion. In
stock-market trading and investing, one must mark to market every day. That means that you never have gains;
it's all capital. And you're never making up for losses. Losses are gone; they don't exist. Ones
realized/unrealized profit & loss is an irrelevant factor in an investment decision; the market doesn't care whether
you're sitting on gains or losses. Thus, this factor needs to be blocked out of ones mind. This is incredibly hard to
do.

So the essential problem here was emotional, not intellectual: I sought comfort in past patterns. And I was
uncomfortable with the fact that I was sitting on enormous gains that I didn't want to give up. Thus, I was
psychologically predisposed to fall into a correction theory that would simultaneously allow me to take profits and
at the same time, place me in a comfort zone in terms of past experience.

So where was the hitch in my swing? Certainly, there was a hitch in my reasoning process, which became
biased with some of the emotional factors I described above.

But please pay attention: Ultimately, the biggest problem was not the hitch in my reasoning. It was the fact that I
swung at all.

Given the contradictory cross-currents that I had identified, I should have simply let that ball go by. All of the flaws
in my reasoning might not have produced a single dollar of losses if, at that moment, I'd simply had emotional
clarity and discipline.
Did I Do Anything Right?

I think it's important to be balanced when analyzing a trade. Rarely is a trade all wrong. It's critical to see the
nuance.

I think I did some things right. For one, I laid out some pretty specific rationales and conditions that served as
checkpoints. I also had a specific timeframe within which my scenarios needed to work out. It's important to frame
a trade in falsifiable terms.
Another thing I did right was to keep the size of my bets fairly modest. I didn't bet heavily against my basic
medium-term view. It was a short-term trade and I sized the position accordingly.

I also correctly identified the potential weaknesses of the trade in advance. In particular, I identified the fact that
way too many people were expecting a correction. And I think that I correctly identified the fact that strong flows
seemed to be driving the market, which would ultimately limit the downside.

Finally, as the trade developed and it went against me, I didnt act on the anxiety I felt as the market shot up.
Several times I was tempted to close out the bear positions, reverse, and go long, chasing the break out - but I
resisted. Perhaps I missed out on some money by doing this, but proper mechanics dictate not abandoning a
strategy while in the heat of battle unless the fundamental rationale behind the strategy has been clearly falsified.
Conditions on the battlefield always ebb and flow, and it's imperative to allow a strategy to play itself out.
Abandoning a strategy in the midst of battle merely because of the ebb against you is a sure way to lose money
over the long term. I respected my stops.

How Did I Deal with Failure?

Feeling like a chump, it was extremely hard to pull the trigger on putting long positions back on, despite the fact
that this is what my medium-term view strongly suggested I should do. In particular, it goes against every emotion
in my being to chase the market. And it was excruciatingly difficult to buy stocks that were up huge since I'd sold
them 3 weeks ago.

My pride had been hit. And emotionally, I was being strongly influenced by a feeling that if the market did correct
after I got in, I was going to be feeling like the biggest fool on earth.

So how did I deal with this?

The most important thing I did was to recognize that the above feelings of pride, shame, fear, etc., are emotions
that have absolutely no value from an investment standpoint. On the contrary - they're totally destructive
emotions. They get in the way of making carefully reasoned and weighed decisions. These emotions are killers of
good investment performance.

Recognizing these emotions as problems is an important part of the solution.

The second thing I did was simply clear my mind and heart and look at this market from a totally fresh
perspective. I needed to completely forget what happened in my last trade. This was really hard to do.

I don't think it's an exaggeration to suggest that successful trading and investing requires the emotional strength
of a Zen master. Seriously. Investing, above all else, is more an emotional discipline than an intellectual one. Skill
comes with deliberate practice. And the greatest advances in strength are derived from how one deals with
failure.
Conclusion

There are no guarantees of success in investing. In fact, the only thing that's guaranteed in investing and trading
 is that you'll fail many times. But you must prepare emotionally for such inevitable failures. And no matter how
much preparation takes place, dealing with actual failure will be harder than getting ready for it.

Indeed, you have to prepare yourself for the possibility of multiple, consecutive failures - and structure your
positions such that you can absorb a large number of consecutive failures.
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It's also important to keep in mind that there's no such thing as a trade or investment that you're going to get into
and be up on as soon as you establish the position. In fact, if you use limit orders, as I almost always do, it's of
statistical necessity that you'll almost always be down immediately after establishing the position.

No matter how much you perfect your knowledge and skills, you'll experience failure in trading and investing.
Constructively accepting -- and appropriately dealing with -- failure is at the core of successful trading and
investing.

It's been said many times, and it's true: In order to become a good trader and investor, you must learn how to lose
money.

However, even more important is knowing what to do after losing money. Lessons must be learned and
remembered. However, they must be the right lessons.

One must vanquish from ones mind, heart, spirit and soul all of the destructive emotions that are associated with
a failed trade or investment. These associations are false lessons. Failure to vanquish emotions associated with
past failures can emotionally predispose one to behave in such a way that is suboptimal in the future when
circumstances are similar, but different.

For example, if I were to carry over emotions associated with this failure, I might be inclined in the future to stay in
a rally to long for fear of getting out too early. I might associate future experiences with this recent one when in
fact, the two situations may be significantly different.

Remember: Investing is more an emotional than an intellectual discipline.

Become self-aware. And become the master of your thoughts and emotions in relation to the flow of events. In
investing, you can rarely change the relevant economic and financial events; you can only master the way you
think about and emotionally relate to these events.