About Losses and Gains

If a trader has a long position, then prices need to rise before
he/she is gaining any profit. If the trader is short, then prices must
decline to make him/her a profit. The market moves regardless of
the position of one particular trader. In order to make money
trading, one must be positioned on the right side when prices are
moving. There is an indefinite number of methods used around the
globe, to increase probability of getting positioned on the right
side. However, nobody knows for certain whether the market will
rise or decline.
When the market moves against the trader’s position and he/she
decides it is time to close the trade, the price movement multiplied
by position size determines the size of the loss. Accordingly, the
risk can be estimated as the drop from entry point to exit point,
that is, the difference between actual buying price and
predetermined selling price multiplied by the number of shares
sold. Following this reasoning, the potential profit that one can
receive depends on price rise and position size. Mastering these
two concepts “Cut your losses short” and “Let your profits run”
seems to be the common denominator making the “market
wizards” so successful, rather than having a high percentage of
winning trades, being able to pick the “right” stock or ignoring a
losing trade.
When a loss is realized there is an obvious mathematical rule
regarding drawdowns affecting recovery that sometimes is
overlooked. If losing 1,000 SEK out of a total of 10,000 SEK (a 10%
7
loss), then to get even, there is a need of a 11.1% increase on the
remaining 9,000 SEK. The larger the loss, the greater profit must
be obtained to recover (see Table 1). A 30% loss requires a profit
on remaining capital of 43%. That is more than twice as much as
the broad “Generalindex” of Stockholm Stock Exchange rose
during the eleven years from the beginning of 1990 to the end of
2000 (an average of approx. 16% annually; “Generalindex” rose
from 1231 points at 1989-12-29 to 4735 points at 2000-12-29, a
total increase of 285%). Taking losses bigger than that requires
extraordinary profit compared to index, and still that is just to
recover!
Table 1. Drawdown effects
Size of draw-down on
initial capital
Percent gain to recover
5% 5,3%
10% 11,1%
15% 17,6%
20% 25,0%
25% 33,3%
30% 42,9%
40% 66,7%
50% 100 %
60% 150 %
70% 233 %
80% 400 %
90% 1000 %
The importance of cutting losses short is obvious. If the trader is
unable to survive in the markets on a near term basis, then he/she
will not be around when opportunities arise to make money on the
long term. Again, the price movement multiplied by position size
determines the size of the loss. The greater the number of shares,
that is, the position size, the greater the loss. The quotations
below, from Schwager (1993), reflect a top trader’s view on
managing risk.
8
Risk management is the most important thing to be
well understood. Undertrade, undertrade, undertrade
is my second piece of advice. Whatever you think your
position ought to be, cut it at least in half [Bruce
Kovner] (Schwager, 1993, p. 82)
To sell an asset that is losing money is definitely a measure being
questioned. Weekly, there are experts and analysts participating in
talk shows and news broadcasts on national television, reassuring
small savers to ” . . . just sit tight”, ” . . . if you sell now, you’ll sell at
the bottom” and ” . . . speculating in stocks is a long term
business”. However, it can be somewhat arduous to maintain this
strategy when there have been down moves from peak to trough
of 75% on a stock, by itself representing 40% of the major index
when trading at all time high (Ericsson B, 2000-03-06 — 2001-03-
17, Stockholm Stock Exchange, Sweden). Especially hard, when
fund managers and “the big money” have been selling the stock the
entire journey down. This can be seen as the number of
shareholders more than doubled, from 272,000 to 586,400, during
the decline throughout the year (Sundin & Sundqvist, 2001).
Nevertheless, for those trading the stock markets there is little
advise to follow but to buy. The short selling recommendations are
very few, as are the recommendations to sell in order to take
profits. According to U.S. statistics: of 28,000 recommendations by
brokerage-house analysts, 99% of those recommendations on U.S.
companies were “strong buy”, “buy” or “hold”. Only 1% of the
time, analysts recommended “sell” (Thomson Financial/First Call
Corp., 2001.) The “dot-com” companies’ rise and fall, another
trying example for the long term buy-and-hold strategist, seems to
validate a more than 70-year-old biography quotation: “The big
money in booms is always made first by the public- on paper. And
it remains on paper” (Lefèvre, 1923/1993, p. 265).
Further, when trading options and futures, which are time limited
by their nature, there is no choice. A paper loss will become real,
since there is someone else, the counterpart, who will close the
trade for you. To close a trade with an unrealized loss or not is a
topic by itself, but will not be addressed any further in this paper.

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