If you’re trading correctly, sticking to your trading plan and following the black & white rules of your systems then life as a trader isn’t stressful. In fact, it’s actually kind of boring after you become good at it. And boring is the way it should be.
However, just about every trader goes through a period where they are stressed out for one reason or another. What usually stresses them out are outlier losses or a long string of losses.
Believe me, I’ve been there.
What is the number one cause of large losses in trading? The lack of stop losses.
One of the reasons I strongly advocate new traders start with trading options is that it short circuits the number one pitfall that makes trading stressful.
When we place our option trades, we use proper position sizing and campaign management techniques that we teach that ensure no stop loss is needed.
Let’s go through an example.
If we had a $10,000 trading account and we used our entire account to buy EVIL corp at $250, we could buy 40 shares of EVIL corp at $250.
If our maximum loss on any given trade is 1% of our trading account, that means we should place our stop loss order at 1% below $250. 1% of $250 is $2.50, so $250 – $2.50 is $247.50. Follow so far?
That means we should place a stop loss at 1% below $250 which is at $247.50. If our stop loss is hit, we can take our lumps and move on to greener pastures. This is paint by numbers simple.
1) Buy stock
2) Place stop loss 1% below purchase price
I’m fairly confident we could teach a 4 year old to do this. Yet most new traders will really struggle when faced with a live trade that’s gone against them.
What typically happens is our monkey brain takes over: “Well, the price has moved back down to $240 now, but if it doesn’t move below my 200 SMA line sitting at $235, I’ll hold onto the stock and hope it rebounds.”
Shortly after the stock drops down to $225 and instant amnesia sets in. After all the 275 SMA is waiting only a few handles away and is sure to hold up.
Essentially the monkey is running the show now with fairly predictable results.
“Well, it’s already down to $225. But look – it’s fallen this far, what do I have to lose? If it just gets back to $235, I’ll close the trade and take the loss.”
Now the stock plummets down to $200 before they finally panic and sell. What should have been a 1% loss is now a 20% loss. That’s stressful.
When I started training Aikido many years ago, I signed up at a prestigious L.A. dojo in the old garment district that was renowned even by Japanese aikidokas who regularly visited in hopes of training with our sensei (RIP).
There was a large crop of students new to Aikido that all started as white belts at about the same time as me. In our very first practice sensei did a basic demonstration and taught us a key lesson which still took me a whole year (and a lot of painful landings) to understand.
One thing he pointed out repeatedly is that Aikido is all about technique, and not strength.
Women happen to understand this ornately much better than men. You see, most women don’t have the benefit of excess physical strength, so their brains work a bit differently.
They aren’t thinking about how they can take an opponent down with strength, instead they are focused on technique.
Because of that, women get better at Aikido quite a bit faster than men, typically 2-3 times faster. I experienced this first hand and it was hard for my ego to handle. For quite a while.
There was a 5’3” 97 lb Korean woman who was a blue belt. She would routinely throw men around the room and usually had me on the floor in 20 seconds flat.
Even after I’d been training for two years. I can’t tell you how frustrating that was for my male ego. Especially since she was hot AF and winked at me every time I ended up on the floor. And not in the way I’d hoped.
Most of the women I started training with made it to blue belt in less than two years, which is insane. Most of the men take at least 4 years, more like 5 years of training to make it to blue belt.
If it takes you less time than that you’re either uniquely talented or ended up at a McDojo.
Aikido is not about strength, it’s about technique. In trading, it’s not about being “right”, it’s about following a system.
If your system calls for placing a stop loss at 1% below your entry price, then the proper technique is to follow your system and do just that.
But most new traders will really struggle with this. Their ego has them trapped in “must be proven right”, which effectively means “avoiding to be proven wrong”. The way our brains naturally work is to see a stop loss being touched as “being wrong”.
Most of us actually spend years retraining our brains because that is not the case at all. Being wrong and taking a loss is part of the process of trading and should be embraced along with booking a win.
It is exactly for this reason, I vigorously recommend all new traders start trading options as soon as possible because it almost completely avoids this cognitive bias.
Why? Because it gives you the ability to define your maximum loss potential the second you take on a trade.
For example, if I buy a vertical spread then my maximum loss is clearly defined and can never exceed the cost of the premium I paid.
Which has a hidden side benefit most retail traders are completely unaware of.
As option traders we clearly differentiate between the probability of expiring at or beyond a certain price vs. the probability of touching or exceeding a certain price.
What that means in plain English is that EVIL corp may have a slim probability of closing below your stop loss at $250 by next week but much higher odds of dropping below it and then bouncing back a day or two later.
In addition the probability of touching increases proportionally to the square root of time. The more time the higher the odds a particular stop may be swept.
When trading options intra-day or short term volatility matters very little as no stop loss orders are required. Your option spread may be worth nothing right after EVIL corp drops through $250 but then may book you a win next week when it suddenly reverses and breaches above $280.
Which happens ALL the time… especially since 2020.
People often tell me they’re not experienced enough to trade options. I usually retort that they are not experienced enough NOT to trade options 😉
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LIVE cumulative P&L of all my trades over the past year can be found here.
See you on the other side.