Learning to Trade 107

There are two intuitive tendencies of investors and beginning traders that need exposure in order to avoid. Experienced traders know them, and use them for profit.

First, after buying a stock and it declines, the tendency is to hold it until it at least returns to breakeven. This tendency is so strong that investors hold stocks for years, waiting breakeven, and sure enough, when a stock’s price returns to former highs, it pauses as those persons finally cash out.

This tendency is so strong, traders jokingly define “Investor” as someone holding a stock at a loss, and a “long-term investor” is someone holding a stock at a substantial loss. After the last year, we have a lot of long-term investors.

Double tops are made from this tendency. The handle of the cup-with-handle formation also comes from this. A double top is a pattern where sellers overwhelm buyers and sends the stock downward in reversal. The handle of the cup-with-handle is where buyers overwhelm the sellers getting out at the old high. Knowing and reading these patterns provide the trader a known position where reward greatly exceeds risk and a close exit point should the pattern perform adversely instead of as expected. Many traders use the day’s new 52-week high list, or a better, a list of all-time highs, to shop for trades. A new appearance on this list indicates a stock that has overcome this drag on performance, and has no overhead.

The hidden cost of this tendency is opportunity cost. While awaiting a breakeven exit, maybe for years, one cannot invest in other situations, which may have even doubled one’s money. The other cost is even more subtle and destructive, a loss of confidence.

The second tendency involves buying a stock that subsequently rises. The tendency here is to hold this stock even when it later declines, even back to the point where one purchased it. This tendency stems from a desire or hope that the stock will continue to rise; that one would miss out on this potential profit. The tendency assures just that, missing out on the profit. Some sell when the stock finally reaches the purchase price; others hold it for a loss, thereby going into waiting for breakeven, someday, maybe.

Ironically, the two tendencies taken together means the investor tends to sell stocks at the price they bought them for, no matter how many years that takes. Might there be something wrong with this picture?

The obvious solution to these tendencies is to be aware of them and take action to not fall into their clutches. First, purchase a stock only when it is in a pattern with a favorable statistical expectation of profit--and know that profit potential. That means having a calculated price target. Should the stock perform as expected one can either take one's profit, or using a trailing sell order, called a trailing stop, to exit the position should it subsequently retrace is price appreciation. Since stocks tend to perform as "two steps forward and one step back" (50% retracement is common), one can raise the sell order by one-half the price appreciation, adjusting it periodically or as needed.

Should the stock subsequently perform adversely, have a stop-loss order to exit the stock with a minimal loss. When these execute, one should not feel as if one had failed. Better to expect such losses, and be thankful they save one being tied into a failed position. Should the price rise as expected, one can raise this stop-loss order which becomes one's trailing stop.

These orders can be calculated and placed when one is not stressed making a decision in an emotional moment, and these orders stand sentinel when one is not watching.