What Managing Other Traders Taught Me

By Larry Benedict, editor, Trading With Larry Benedict

Throughout my trading career, I’ve managed hundreds of other traders.

No matter how smart or talented they were, various events could lead to them blowing up their accounts.

A war, coup, surprise downgrade, or shock employment number is par for the course. But how do you anticipate something straight out of left field?

For example, think back to the flash crash in 2010… The Dow Jones lost 1,000 points (and around a trillion dollars in market value) in around 30 minutes before recovering just as quickly. My hedge fund experienced an $80 million swing that day…

No one can predict when a calamitous event will strike and wipe you out.

But there are certain mistakes you can prepare for. And that’s what I’d like to look at today…

Common Mistakes

The number one mistake many traders made was that they didn’t use stop losses. That can be a massive, massive (and often life-changing) mistake.

A stop loss simply represents the level where you accept that you're wrong. Without making that decision, how do you know when to exit a position?

These traders were so confident in the rationale behind their trades that they just couldn’t contemplate that they could be wrong.

With stop losses, there is also another dilemma…

Traders often avoid them out of the fear of being stopped out right before the anticipated moves play out. And to be fair, that can happen...

It happened earlier this year in Currency Wizard, when a brief spike lower in the USD stopped us out of trades that otherwise would have been profitable.

But you’ve just got to take that on the chin and accept it as a cost of trading. After all, the risk of not having a stop is much greater. A stop loss is a protection mechanism. Without it, your risk is undefined.

It takes just one small loss developing into something much bigger to teach you that the hard way.

Averaging Down

The other common mistake traders made was averaging down. They kept buying as the stock was tanking, believing that the stock would eventually bounce.

But this led to huge and irrecoverable losses when the stock kept breaking lower.

The problem with averaging down is that it ties up more and more of your capital (leaving you increasingly vulnerable) when you should have already abandoned your position.

This leads back to why I trade options for many of my trades…

For a small outlay, an option gives you access to a leveraged position that can generate serious gains. A $3 option (or $300 per option contract), for example, can give me exposure to 100 shares of a $500 stock.

And with options, you know your maximum loss – the premium you paid for the option. Your risk is clearly defined…

So if an option contract costs me $300, for example, then I’m risking $300 on my trade – no more, no less. If the worst case plays out and my option expires worthless, I’ve already decided that I’m prepared to lose that amount before I place the trade.

And because I’m using just a fraction of the capital I would use compared to buying stocks, I can have more than one bite, so to speak, on a trade.

But better still, when the next surprise shakes the market, I know I’ll be calm when everyone else is panicking…

I’ll have my risk under tight control, and I’ll be ready to take the next swing at bat.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict