From the February 01, 2008 issue of Futures Magazine • Subscribe!

Avoiding bad trades

When it comes to distinguishing a bad trade, perspective is everything. If you’re only interested in immediate financial satisfaction, then the definition is simple: winning trade, good; losing trade, bad. How you came to profit is irrelevant. It only matters that you profited. However, if your trading goals involve long-term success, as most do, then what makes a trade bad might not be so clear-cut.

Experienced traders often will say that some of their best trades were losers that because of circumstances could have been much worse and some of their worst trades were winners from which they failed to extract the full profit potential.

“A bad trade is simply a trade taken for the wrong reasons. If you have a system, method or theory about trading, and take a trade that does not follow that system or method or theory, then that is a bad trade,” says David Penn, senior editor for TradingMarkets.com. “You may make money or lose money; after all, anything can happen. But it is a bad trade because there is no accountability for it, no track record to follow. It is just a stab in the dark.”

Paul King, of PMKing Trading LLC, says that relative risk and reward define a bad trade.

“Because risk and reward always go hand in hand with trading, a bad trade is one where the potential reward is outweighed by the risk,” King says.

But King goes on to caution that risk and reward aren’t just defined by the prospects for price to rise or fall. He says that a bad trade also can be defined in logistical terms.

King identifies several market conditions that can reduce this reward/risk ratio, all of which are rather obvious. They include trading low liquidity instruments, trading instruments with sparse price or volatility history, and trading an instrument when there’s reason to believe your volatility assumptions may be challenged by reality (such as right before an earnings announcement or economic report). King also agrees that trades that do not meet your own pre-defined criteria or trading plan also fall into the bad-trade category.

Let’s consider several ways that bad trades occur — before and after entry — and look at ways you can avoid them.

AVOIDING THE BIG MOVE

New and small traders need to be careful where they tread. Some markets move too far and too fast for the faint of heart. These volatile markets are fine if you can handle the swings, but they’re generally not a safe place to get your trading legs.

Of course, volatility isn’t all bad. Indeed, on the most fundamental level, volatility is simply the movement of prices, and that’s something every directional trader needs to make money.

“Volatility can be a great thing if you know how to handle it,” says Lee Lowell, author of Get Rich with Options: Four Winning Strategies Straight From the Exchange. “Sometimes volatility can whip you in and out of trades at the wrong times. The best way to deal with volatility is to reduce your trading size until you are more comfortable with the environment.”

King agrees: “As long as you develop methods that adapt to changes in volatility — by reducing position sizes, for example — then volatility is something to be sought out, not avoided. If you get into a stock, for example, that is flat-lining [in terms of price movement], how exactly are you going to make money on the trade?”

But adapting implies that you have time to make changes. Sometimes volatility does things that you don’t expect. Often, these periods directly result from market reports or other market shocks that cause big moves in price. Unexpected news always looms over the market, and much of it is nearly impossible to predict, even for the most experienced traders. However, many potential market shocks are announced well in advance. Major government reports can (and will) reveal data that markets were not expecting in advance. Even small diversions from expectations can have a big impact on price.

One way to deal with excessive volatility that may result from upcoming reports, King says, is to trade what he calls “outside the noise.”

“I recommend using wider stops with longer average trade duration and not having to worry about increased volatility whipsawing you out because your stops are too tight,” King says. “Trading short-term with tight stops through major announcements is a good way to guarantee you’ll lose on the trade even if you turn out to be right after the fact.”

Another trick is knowing when a market’s noise level might rise above average. One example was the Dec. 11, 2007, announcement by the Federal Reserve that it was dropping its target for the Federal funds rate by one-quarter of a percentage point. The stock market, ostensibly expecting a half-point cut, responded with a huge jump in volatility (see “Ready for that?” page 58).

MAKING A BAD TRADE WORSE

Sometimes, you’re just plan wrong. Say that you make a fundamental mistake — you enter a trade on a hunch — and the market immediately moves against you. You’re quickly in a financial hole and you’re feeling pretty bad about your original decision.

So, you do what many new traders do in this situation: You add to the position.

This is commonly referred to as averaging down but a better description could be chasing a loser or throwing good money after bad. “This is one of the cast iron rules that I never break: Never, ever, add to a loser,” King says. “It’s the epitome of bad trading.” The idea behind this advice is that the market is trying to tell you something about your original reasoning to take the trade. To see what adding to a losing position can do to an account balance if you don’t listen to the market, see the chart “Stacking losses.” Although one losing trade is bad, more can compound the problem rather quickly.

As with most bad trades, however, there is another side. Throwing good money after bad “typically means that a trader still will put more money into a trade even after it starts to move against [the original position],” Lowell says. He adds, though, that in some cases “this is fine if you still believe the trade has merit.” So, if the trade still fits within your trading plan, if you have done your analysis properly, if you trust your logic, and if the facts surrounding the matter are still true, then it might make sense to add to a position, regardless of where price stands relative to where it was when the trade was made. But there has to be a point in every trade — either based on price or time — where you acknowledge that you are wrong and get out.

“If you’re throwing more money into the trade because your ego will not let you take the loss, then you are in fact throwing good money after bad,” Lowell says. “This is the case when a trader can’t admit they’re wrong.”

OVER-EXTENDING

Trade entry and exit is only one aspect of a trading plan. There’s also money management. Money management simply refers to how you manage the money you have to commit to positions in the market. In other words, it describes rules such as how many contracts you trade, when you add an additional contract to a position, when you take profit and how much of an absolute loss you’ll allow your trading program to absorb before you retreat to the sidelines.

For some, the lack of a proper money management strategy is the worst “trade” you can make, and one of the worst examples of poor money management is over-trading. One description of over-trading refers to assuming positions that are too large for your account size. In such cases, even if you are ultimately correct in the timing and direction, an adverse move in the meantime, and the losses that ensue, could see you knocked out of the market before your trade has a chance to work.

Poor money management is the culprit in many bad trades, says Howard Tyllas, a member of the Chicago Board of Trade and president of Futures Flight. “Just because a trader has enough margin to place a trade, [doesn’t mean he is exercising] money management. Many markets now move $3,000 in one day.”

Instead of simply relying on margin requirements, you need to perform a thorough analysis of both the market you are trading and your trading approach. Your goal: find out how much “normal” volatility your account must be able to absorb per contract. If you can’t afford to ride out those market fluctuations, then you need to find a different market, a different strategy or a bigger account.

Similarly, Tyllas says that a bad trade can be described as one that does not allow for enough upside to make the potential downside worth the risk.

“When you risk more than you are going to make if right, that is a bad trade,” Tyllas says. “If you risk $2,000 to make $1,000 in this business, you won’t last.”

REACTION

Of course, no trading plan is perfect. You may believe a trade falls into the framework of your well-laid plans, but that it didn’t may not become clear until after a position is entered. For example, previously unknown fundamental data may become available that drastically affect the logic for taking the trade — or a negative technical condition might suddenly develop. This is different than a bad trade that is taken for all the wrong reasons, such as a fleeting hunch or bravado.

If such a change in course occurs, the trade may still result in a loss, but if you handle it appropriately given the new market environment, then you’ve done everything a good trader can do.

“A trade is also considered bad if you know that the fundamental and technical picture has changed for the worse, but yet you still don’t do anything about it,” Lowell says. “Professional traders will cut their losses when they no longer feel the trade is worthy. Everyone will have bad trades. The key is what you do with it when it does go bad.”

The flip side of that advice is that any trading approach will have extended periods of success. It’s easy to feel like you know what you’re doing then. But your true measure will be taken when you encounter periods when your trading isn’t going well.

Depending on the scenario, your proper reaction might mean scaling back the position, putting on an offsetting position in a related market, adopting some options positions or, simply getting out of the trade. Knowing how to respond to a good trade gone bad is as much a part of a successful trading plan as the analysis that triggers a trade entry. But if you consider the bad times before they occur, as they specifically relate to your trading approach, you will be in a much better position to deal with them when they inevitably happen.

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