The Secret to Managing Losses and Hitting Home Runs

I have worked as a market strategist for the past 15 years alongside a few thousand retail and institutional investors in foreign currency, futures, equities and options. A common experience amongst self-directed investors is a repetitive string of small winners, followed by a few big losses that wipe out weeks or months of gains. As investors struggle with this, many turn to following the “professionals” or seek “better” trading strategies, which rarely turn their portfolios around. This is because the common theme to successful traders isn’t their strategy or which indicators they use, but rather their process for risk management. In this post, I highlight the best practices of professional traders where discipline of risk management is the primary key to their success. To learn more about managing winners, please view our latest webinar on this topic.

Preventing Huge Losses

There is no shortage of empirical evidence and studies, examining how humans skew our view on risk and reward. Research shows that accepting a loss is viewed to be twice as painful compared to the same amount of gain. This leads to the behavior of hanging onto losers far too long and closing winners far too soon.

The reality of investing is that there will be losing trades and one must first accept this as a fact. In my experience, it is the pursuit of preventing small losses that ironically triggers some of the largest losses. We may have all experienced having a small loss, adding to the position with the hope of getting back to breakeven, only to have the position decline even further into a larger loss. Unfortunately, some investors will compound this habit, resulting in a total account blowup or loss. This begs the question; how do we trick our brain into turning this around?

To help with this quirk of human nature, professionals turn to a rules-based approach. First, there needs to be a decoupling of the concept of winning trades from being profitable. While the two are correlated they are not bound together. Most investors that struggle, make the incorrect assumption, that if they just win more often, they will be profitable. However, evidence shows that it is far more likely that a few big losses are typically what pushes accounts into the negative. To this point, the primary focus of investors is not to prevent losses in the first place, but only to prevent large losses. This can be achieved through discipline with the help of trading tools such as stop loss orders, option strategies with limited risk, and never risking more than 2% of your account per trade. Moreover, it is best to never add risk to a losing position.

Hitting Home Runs

With a ruled based approach to cutting losses, professionals actually spend the least amount of time managing losing trades. The primary focus is spent on managing their profitable trades. Whereas, I have found that most investors who struggle, find the exact opposite to be true. Once a habit has been formed with a rules-based approach to cutting losses, an investor can focus their attention to trades that are profitable and how to turn a small winner into a much larger one. While the rules for cutting losses are fairly straightforward, the rules for managing winners depend on the profitable trade. We have put together a few scenarios where a trade moves in the investors favor, and how an investor can take risk off the table and play for further upside. In each of these, we explore rolling a profitable options strategy to reduce risk and play for further gains.

In the following examples, we are using stock BMO on Aug 27th, 2020 trading at $83.78 and the investor has purchased 10 Contracts of the Oct $84 (At the Money) Call Option for $2.35 per share or $2350 in premium. ($2.35 x 100 x 10 contract = $2350 premium) In this example, the trader had an outlook that the stock would rise to $90.

1. Scenario: BMO makes a modest directional move to $87 with 3 weeks to expiration and the investor still has the same outlook of $90 at expiration.In this case, the roll strategy could be to close half the position by selling 5 of the $84 calls @ $5 ($5.00 x 100 x 5 = $2,500 premium received). This allows the trader to still have 5 contracts open until expiration while eliminating the initial $2350 of risk. If the stock continues to rally, this trade will produce a minimum profit of $150 ($2500-$2350) with unlimited upside potential. This roll strategy requires at least 2-3 weeks remaining before expiration.
2. Scenario: BMO makes a modest directional move to $87 with 3 weeks to expiration and the investor believes that the stock will take longer to reach the $90 target.In this case, the roll strategy could be to sell all 10 contracts of the Oct $84 Calls @ $5 ($5000 premium received) and buy 8 contracts of the Nov $86 Calls @ $5 ($4000 premium paid). This strategy allows the trader to effectively finance a whole extra next month with a $1000 credit. The overall risk on this trade has been reduced from $2350 to $1350 from the $1000 credit received on the roll. The overall leverage does decrease as only 8 Nov contracts are purchased using the premium paid from selling the 10 Oct contracts. However, this gives the investor an extra month for BMO stock to reach the target of $90 a share.
3. Scenario: BMO hits the $90 target with 5 weeks to expiration.In this case, the roll strategy could be to sell all 10 $84 Calls @ $8 ($8,000 premium received) and buy 15 $90 Calls @ $2.50 ($3,750 premium paid), This creates a net credit of $4,250 and the overall risk is therefore reduced from $2350 to a minimum profit of $1900. Long exposure is maintained with a guaranteed profit and an increase in leverage as there are now 15 contracts of the Oct $90 Call options to play for further upside and potentially even higher profits.

As a market strategist, I can admit that while these scenarios do not happen every day, when attention is shifted from managing losers to winners, it opens up the possibilities to explore turning small winners into huge winners. This shifts a portfolio from small wins and big losses to small losses, small wins and the occasional home run.

Summary

It is important to remember that the end goal is to become profitable over the long term and not to “win” as many trades as possible. Even with a few losing trades, if the loss incurred is larger than multiple winning trades, it eats away at your long-term profitability and eats away at your trading account. Using a rules-based approach to keep losing trades small is easier said than done due to the psychology in play. Naturally we lean towards taking small profits while letting our losing trades ride in hopes that it reverses back to a winner. By focusing instead on rolling profitable positions, you open the opportunity up for potential home runs and shift the tide from occasional large losses into occasional large winners.