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Today’s topic might appear to be a fun one, but, for the unprepared trader, there is actually serious danger here. What do we do when a trade results in a larger than expected win? What do we do when volatility becomes much larger than when we put the trade on, but we have significant profits. In other words, what do we do when the market gives us a gift?

Volatility

In strong trends, volatility often increases dramatically. Near the end of those trends, volatility sometimes explodes. (In fact, this dramatic increase in volatility is one of the signs of a potential trend reversal.) Most traders use some volatility-aware methodology to size trades; in some cases, this is obvious, as when trading size is calculated based on some ratio of ATR or historical volatility. In these cases, the intent is to have each position contribute roughly the same amount to the daily changes of the trading account. My approach is to base stops off of reasonable swings in the market; though not as obvious, this is still a volatility-adjusted methodology because I will have larger positions in quieter markets. As a market trends, volatility can expand dramatically, so all of these measures go out the window. Do you see why pyramiding into a strong trend is often exactly the wrong thing to do?

Danger of climax and reversal

One of the characteristics of strong trends is that they tend to reach overextended points, and then snap back sharply from those points. Though the snapbacks might be temporary, they are enough to cause serious damage to traders who become overly aggressive in trends. Imagine the case of a downtrending stock, a trader sees the market open strongly down and shorts more into it (in these cases, traders often double or triple up!), and then the market reverses. Even if that reversal only lasts a few days, it may be enough to carry the entire position, which was a substantial win, to a loss. Psychologically, this is devastating. Of course, not stopping out of a reversal like this can lead to utter trading ruin as there is always the possibility the reversal is not temporary. (Fun fact: my very first trade in wheat involved pretty much paying what turned out to be the multi-year high for quite a while. The psychology around these points basically encourages mistakes.)

Psychological risks

Extreme points in trending stocks pose many psychological dangers. If you are not in a market that is really moving, you find yourself thinking some silly things like “I am the only trader not in this move”, “I must get in this move before they change something in the market and take this opportunity away”, “if I had been in at XXX, I could buy a new car.” If you are an institutional trader or manager, then there is the sense that all your clients are reading stuff on Yahoo! about the stock, and you are on the only manager who missed it. At any rate, there is a real danger of “chasing” the market, which means putting on positions at less than ideal points. The professional approach is to either wait for a consolidation that offers a real entry, or just know that you missed the trade. Sometimes, we will miss trades, and that is ok. No one can catch everything.

If you are in a trade that turns into a huge, outsized winner, now there are a few things you need to watch. You become your own worst enemy here, and there are a few common mistakes traders make in these spots. Here are some things to think about:

• Monitor your behavior. If you find yourself doing something you do not usually do, you are standing on the precipice of great danger. Are you checking your account balance more often? Are you calculating what your wins will be if it “moves like this three more days”? Are you looking for a spot where you can “put on just a little more”? If you normally do those things, great. If you started doing them because of this trade, this is an early warning sign of psychological stress, and you may be about to do yourself harm.
• Distance yourself from the situation. You may need to get help here, but make sure that every action you take is measured and correct. Perhaps put yourself on a delay. Depending on your timeframe, this could mean waiting anywhere from 30 minutes (if you are a daytrader) to a few days before you do anything new.
• Do the right thing. Many of us enter trades with predetermined points to take partial profits. If you are convinced you have a big winner, there may be a tendency to skip these exits, but this is just another way to have too much size on. Size kills. Continue reading…
• Get smaller. So many times, this is the answer. When the P&L swings from a position start threatening your discipline, take some of the position off. First, get out of 20%. Ring the register. See how you feel. Still edgy? Get out of another 30% so now you’re half sized. Yes, I realize this is exactly the opposite of what you want to do, but that’s why you need someone to tell you to do it.

One of the challenges of trading is that both wins and losses can be larger than expected. We spend a lot of our time and energy focusing on managing the losses, but the risks of winning trades also demand attention. Sometimes markets do give us “gifts”, and we have to be prepared to do the right thing, manage the risk, sidestep the greed, and take our hard-earned profits.