LIKE A NEW LOVE, the beginning of a journey or a fresh hand of cards, the first trade in a particular stock is exciting and seemingly rife with possibilities. But the toughest and most important trade you make is actually the second one. Happy relationships, smooth travel or winning blackjack all require skillful reaction to changing circumstances — and so does successful trading. What matters is the all-important follow-through. In every market and with every product, managing a trade is even more important then making it in the first place.
Anybody can buy a stock. It’s how you manage the fallout that matters. Lots could happen: The economy could slump. Or interest rates could rise. The company’s sales could falter, or its CEO could get run over by a bus. This is the problem with following the fundamentals. It means concerning yourself with things that are far out of your control.
What really matters ultimately is the price action of the stock itself. When you buy XYZ at $50, there are only a few possible outcomes. XYZ could go up, down or go nowhere at all. We will briefly outline what I believe to be the time-tested rules for what to do next.
Let’s assume XYZ rises to $55, whether thanks to prayer, skill or just plain old luck. Even in a tough economy with soggy stock indexes, there’s always a bull market somewhere. You’ve got a winner on you’re hands, so forget the headlines. You’re up five points on XYZ…what’s your next trade?
The easiest, most appealing and seemingly safest follow-up would be to simply sell the stock. Heck, you made money on the trade! That’s the point, right? Take the profit and move on to the next big winner.
Not a chance!
It’s my sincere belief that whoever came up with the phrase, “You never go broke taking a profit” never had a profit in the first place. When a trade is going your way, do yourself a favor and don’t stand in its way. You can’t sell your winning stocks and expect to make money. I’m telling you because I know — that when it comes to the very basics of trading, that’s how you lose.
As psychologically difficult as it may be, when a stock goes your way, the technically preferable second trade would be to add on, ideally with a slightly smaller position. If you bought 500 shares at $50, buy 250 more at $55.
Sound crazy? There are plenty of traders who’ve never added to a position, and I think they’re missing the point entirely But if you liked it at $50, you should like it even more at $55. Because now $50 is just a pipe dream for those who weren’t as cunning as you. You’ve got a pair of aces. And regardless of what the headlines are, the price action is bullish. As a general rule, that’s about all you need to know.
There are only two times when you wouldn’t want to add to a winning trade. If adding to a position would significantly overweight your portfolio in XYZ, say over 20%, don’t do it. Also, watch the size of your additional buys. Just add to the position, don’t drown yourself in it. As always, trading isn’t about black or white, but shades of gray.
The other time when you might not want to add to a trade is if its move is accompanied by a great deal of public bullishness. Newspaper articles. Mentions on financial Web sites. Analyst recommendations. That sort of thing. You simply shouldn’t follow the herd. By the time most pundits pick up on a good idea, the real move has already been made.
A decidedly less exciting possibility is that, as hard as may be to comprehend, XYZ actually goes down in price instead. It happens. Minimizing losses is just as important as maximizing gains. So XYZ falls to $45. How should you proceed?
Assuming that it’s a strong stock — meaning a leading stock in a leading industry — and that my initial position was no more than 5% of my entire portfolio, I wouldn’t be too much of a hurry to cash out, even if XYZ did sink to $45 or go nowhere at all. So the second trade in this case might be a “nontrade.” A good old-fashioned hold.
The same thing goes when a stock just goes nowhere at all. It’s more than a little conceited to expect that XYZ is going to immediately bolt up simply because you or I bought a few hundred shares.
I’m not against holding onto a losing trade provided that you’ve invested only a small portion of your overall capital in it, leaving you free to move on to the next opportunity without totally abandoning hopes for XYZ. While there’s truth in the old saying, “Cut your losers and let your winners run,” sometimes you’re not wrong, you’re just early.
But how do you know when it’s time to reduce your position — or sell it entirely? Like most decisions in trading, this one essentially comes down to a question of asset allocation. When a losing position starts hurting an overall portfolio, cut the trade and move on. Or if you are overextended in XYZ’s sector or perhaps equities in general, don’t hesitate to reduce exposure, which is just French for taking a loss.
Maybe you take it all at once. Maybe you take half of your loss, or tax swap into a similar instrument, one simple way to maintain exposure to a particular sector while still grabbing a tax loss.
While it is our natural instinct to want to add to a losing position, I lost large sums of money before I realized that this is precisely the second trade you don’t want to make. Doesn’t matter what the headlines are, or how bullish the pundits are. When a trade is moving against you, it’s because you’re wrong, not the market. The best technique dictates that you take the loss and move on. Fighting the tape is a fight you will lose.
There are many ways to make money in the market, and ultimately every trader must develop a personal style with which he or she feel most comfortable. But I’m old fashioned, and while there are many reasons to get into a trade, in the most disciplined circles, there are only a few options for how to manage one. As in any art form, there is such a thing as classical trading technique. These are the rules, and although you never hear it discussed by the pundits or the chattering heads on CNBC, it’s the second trade (read: the follow-through) that really counts.
Whether it means mustering the courage to stick with (and add to) a winning trade or scaling back on the inevitable losing ones, sound technique is more fundamental to your bottom line than any financial statement or price chart will ever be.
– Originally on Dec 17, 2001 by Jonathan Hoenig
