Ever have that day when you were 100% sure about a trade. You just could not lose, the stock was a real buy, it had already fallen a great deal and it could not possibly fall any farther. So you waited and then plunged in, you couldn’t lose so why not just go big? You bought in and sat back with dreams of what you would do when the stock rose back up to its past glorious price high. You had almost spent the money in your mind when the weirdest thing happened, the stock went down even farther after you bought it. But you were not concerned the stock was an excellent company so it would get back to its highs, you just had to be patient, you would just buy more at these prices, how could you lose? The next day it dropped even more, okay you bought more and felt good about it. You imagined it was another opportunity, you were the next Warren Buffett buying value. You patted yourself on the back and waited. But it kept falling, you started to feel the heat, your account was much lower than when you started on this can’t lose adventure into the abyss. You reasoned “It is only a paper loss, I still own the stock as long as I do not sell I can just wait for it to go back up.”
This story never ends well. What we don’t realize is that either the P/E was contracting because the future growth in the company no longer met analysts expectations so it was being distributed by institutions not bought. Or the market was entering into a bear stage and growth stocks were being sold off to raise capital for cash withdrawals from mutual funds by smart investors selling their mutual fund shares. Or the stock simply peaked out and had gone as far as it could with everyone owning it that wanted to and no buyers really left to come in and push it higher.
What ever the reason this is why you always must have an exit plan and the price that it needs to go to that will mean you were wrong and it is time to sell. Many times the more obvious a trade looks the worse the odds of it being a winner. Most the time the hardest trades to take are the ones that are the winners. The sad thing is while the new trader is losing his account and sitting in a puddle of sweat having a stress attack there is some mellow rich trader who shorted the same stock and is out by the pool with a drink and a cigar counting his winnings. .
Always remember: the most dangerous trade is the one that you think you can’t lose. It makes you trade too big, be over confident, sloppy, greedy, and not use stops.