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Should You Offset Losses With Higher-Risk Positions?

Feb. 10, 2014 8:32 AM ET
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Thomsett's Blog
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Trading is a lot like chess. You need to look several moves ahead, coordinate attack and defense using multiple pieces, and recognize what is going on with both players at the same time. More than anything else, traders need to apply the chess rule when it comes to losses.

In chess, when you lose a piece without an offset, it puts you at a disadvantage. The inexperienced chess player impulsively goes on the attack, hoping to even the score by getting one of the opponent's pieces of equal value. In so doing, this novice chess player abandons defense and opens up an opportunity for the skilled opponent, to increase the advantage.

Although "the market" is not a conscious opponent, it might seem like one. When you make a trade and it turns out to be poorly timed, what should you do? Maybe doubling up on the position in a form of speculative dollar cost averaging will help. This reduces your average cost and, if the trend turns around, doubles your rate of profitability. If.

That's the problem. What if the trend continues to move against you? By doubling your position, you double the rate of loss as well. For an aggressive trader, this might work as long as some basic rules also apply: You believe the price movement is only a short-term swing and is due to reverse soon; the company is fundamentally and technically strong and the current price is a bargain; and you are willing to accept the risk, knowing and understanding what that risk means.

Experienced traders understand that losses are part of the normal routine. They have gained the wisdom to put aside the ego that inevitably comes into the trade. They cut their losses early, put them in the past, and move funds to other trades where their chances of profit are better.

Chess players discover that their game improves when they react to the loss of a piece by going on the defense. The same rule applies to trading. Learn from the loss experience but don't make the mistake of believing a loss is not acceptable. If you can't bear the loss, you shouldn't have entered the trade to begin with. It's really just a matter of wisdom. Chess players and traders alike improve not by how they win, but by how they manage their losses.

To gain more perspective on insights to investing observations and specific analysis, I hope you will join me at ThomsettStocks.com where I publish many additional articles. I also maintain a virtual portfolio of stock at ThomsettStocks.com. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site to learn more.

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