Tuesday, December 30, 2014

New Year's Resolution - Managing Losing Positions

With only a few hours left in 2014, it's high time to start getting reflective and laying out plans for goals and improvement in 2015. No doubt we'll make a couple more poor decisions to close out the holidays (yes I need that 7th cookie and yes I'll have another bourbon) but once the calendar flips, it's time to tackle new challenges.  Tomorrow, Ryan and I will have our annual year-end lunch.  We'll review 2014, discuss what went right and what went wrong and then set our sights on 2015.  In looking ahead, we'll each come prepared with resolutions we hope to achieve in the new year.  They'll be wide-ranging.  Not only will we share our professional goals and what we'd like to achieve as a firm but also personal/lifestyle goals.  Since we're together on a daily basis, we're able to keep tabs on progress and hold one another accountable. 

I share this with you because we want to challenge fellow readers/investors/traders to assess their process in its entirety and be sure to acknowledge where improvements or new goals must be made.  This should be considered routine maintenance by any investor but all too many fail to be truly honest with themselves.  One area where we see many struggle is how to handle losing positions.  This is a primary determinant (if not THE PRIMARY factor) in one's long term success.  Loss management is so important for a variety of reasons but math and compounding sit at the top of that list.  Take a look at the chart below:

Percentage Loss
Percent Rise To Breakeven
             10%                     11%
             15%                     18%
             20%                     25%
             25%                     33%
             30%                     43%
             35%                     54%
             40%                     67%
             45%                     82%
             50%                    100%

Further, at a 70% loss you would need a 233% gain to get back to breakeven.  And not to be too obvious but once you run out of buying power/capital, you can't trade or invest at all. 

One should never allow a loss to grow so large that it makes recovery impossible.  It is imperative to have a line in the sand on every trade at which point you will take the loss and get out of dodge.  Some use tight stop losses while others are willing to allow for wider price swings.  Whatever your preference, a maximum loss tolerance should be a final component in establishing position size.

Being wrong is part of the process and, for most, it happens just as frequently if not more than being right.  The challenge is to achieve a profile where the average winning trade is larger than the average losing trade.  Having that ratio work in your favor over the long-term is a recipe for success.  However, staying wrong and not taking a loss at a certain point is a road to ruin.

Whats more, we have seen the toll large drawdowns can take on an individual.  It is physically and psychologically draining and can cause major emotional damage.  Traders and investors must avoid these pitfalls by having a disciplined risk management process. Preventing small losses from becoming big losses is easy in theory yet very difficult in application.  Finding the right balance in your risk management approach is imperative.

Take a moment as you prepare for a new trading year to make sure your risk management process is air-tight and fits your personality.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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