The act of completing a trade, in essence, is very simple. A trade is simply executing a buy order, holding the ‘open’ position for a period of time and then executing a sell order. Selling short would be the opposite.

The physical act of a trade is very simple. The two transactions (buying and selling) can be placed over the phone with a broker or over the internet via an online trading platform. That is all there is to a trade.

However all the ‘things’ involved with the decision-making surrounding a trade may be quite complex. The complexity is not a physical one, unlike executing a golf shot from 190 metres to the green into a 30 km/h wind, avoiding the lake on the left, the trees on the right and the bunker in the front to land it three metres from the pin.

So you may ask, if the complexity is not a physical one, then what is the complexity, and why is it complex?

The answer is traders create the complexity. It occurs in their minds. Successful traders execute trades—it is what they do and it is simple and effortless for them. Unsuccessful traders spend most of their time struggling and straining through the decision making process of what to buy, when to buy, how much to buy and whether to hold or sell, with each step of their process re-enacting in their subconscious a painful experience from the past. This happens automatically, without any volition, or effort.

As traders and investors, forgetting the past is not always a good thing. In order to learn and grow as successful investors we must learn from past mistakes and put rigour and rules in place to overcome the variables at play in the market – variables over which we have no control. The “largest loss trade” can result from these variables and can be catastrophic to a portfolio. Generally, investors who expose themselves to the largest loss trade are “buy and hold” type investors, investors with no exit strategy and / or investors breaking their own processes and rules.

Now that the market has provided some relief with a recent 55% rise from the lows in March of this year following the Global Financial Crisis crash, those who experienced “largest loss trades” need to sit back and objectively develop a plan on how to avoid a future re-occurrence. History tells us that steep falls in the market index will appear again and those that find themselves in falling stocks need to be prepared to cut their losses rather than employing the ‘hope and pray‘ method guided by the dysfunctional belief “that fundamentally sound stocks always recover”.

There are many examples of stocks that would supposedly recover such as Babcock and Brown, Allco, ABC Learning, MFS, Quintex and One-Tel in the Australian market and Enron, Lehman Bros and many others in the American markets. These stocks went to zero but many others such as Centro, many ASX listed property trusts, Freddie Mac and Fannie Mae fell by huge amounts and just hung on by the skin of their teeth and may take years to recover, if ever. I’m sure that readers will be able to identify their own “largest loss trades” in both high profile companies and little known minnows.

All of the above-mentioned stocks were part of their respective Indices at some stage, the ALL-ORDS or the S&P500. Remember that when stocks fall in market capitalisation they fall out of the index. Therefore their total fall from grace is not registered in the index but their complete fall, should you continue to hold them, will be registered in your portfolio for the rest of your life. This is known as “survivor bias” which is inherent in all stock market indices.

The table below shows the profit required to make back a loss. Total losses up to 30% are recoverable with solid trading processes and adherence to strict rules. When your portfolio losses or losses in individual trades get beyond 50% it becomes tougher to recover and losses beyond 70% become almost unrecoverable. I say almost because I believe that “anything can happen” in the markets. There will be the very odd occasion when a loss of greater than 70% does recover but I would hate to experience that level of drawdown in my active investing activities. The emotional turmoil and associated stress would be a nightmare. In any case, the opportunity loss is unnecssary compared to cutting out of the loss trade early on and re-investing the trading capital into another trade that has a high probability of rising as determined by researched criteria that indicate the high probability.

Avoiding the “largest loss trade” is far easier using technical analysis than using fundamental analysis because analysis of the price action of the stock is more timely than the analysis of fundamentals which are updated infrequently, relatively speaking.

Those using a mechanical approach to the market with no emotional attachment to either the shares in their portfolio or the need to be right, will simply follow the rules of the system and cut losing trades immediately that a sell signal is generated. This goes a long way towards avoiding the ‘largest loss trade’ or other similar outlier events. However, analysis is just a tool or a means to meet an objective. It is only a part of the skill-set required to be successful with investing. The other skills and requirements are continually presented and discussed in this weekly blog.

From the many hundreds of people that called our business during the GFC, I can say that private investors were not alone in holding these largest loss trades. Investment managers and fund managers were also caught up in stocks that went to zero – the only difference being that it was not their own money that they were losing. By sticking to the rules of a trading system with an edge, applying strict money management and position sizing rules, and taking ALL exit signals when they occur will go a long way to helping you avoid the ever present threat of the largest loss trade.

Focus on, enjoy and love the execution process and outcomes will be positive; focus on the outcomes and the opposite will happen; they will be negative over a large sample of trades. This is yet another trading paradox, the degree to which you focus on outcomes will be the degree to which you will be unsuccessful in the market.

Focusing on outcomes will cause trainee traders to miss trades, chase trades that shouldn’t be done, exit early, enter late and risk positions that are too large or too small. These are all mistakes.

Mistakes are caused by fearing the “wrong” outcome. Our fear of a “wrong” outcome is greater than our fear of a “right” outcome. I use inverted commas because our societal paradigm is programmed to define wrong as a loss outcome and right as a winning outcome whereas an outcome is what it is, just an outcome. Most of the time outcomes are caused by variables that are out of our control but we make the situation worse by making mistakes with the variables over which we do have control.

When you execute a process according to its defined routines then all outcomes are “right” and there are no mistakes. Therefore, surrender the outcomes to whatever they will be and put your focus into your actual defined process of trading. Executing a process as it should be executed is easier to achieve when you have done your preparation and have defined a process based around a statistical edge that you trust.

In a nutshell, focusing on outcomes causes inconsistency and erratic actions which result in poor outcomes that cause frustration, anger, denial and dishonesty (with yourself and everyone around you) about performance which can spiral out of control.

For more than 10 years I have had thousands of ‘wannabe’ traders come along to listen to trading methodology demonstrations, with the great majority saying: “Just give me a trading system that is good enough for me to make money—I have no problem with the psychological side of things.”

Wrong, wrong, wrong! The psychology, that is, the approach I am outlining to you, is what it’s all about. With the right mindset you can make money with any system with an edge. However, the edge on it’s own will not guarantee success.

They are working on the incorrect premise that their current way of thinking is at the level required to make a “right” decision and that their mindset is okay for trading, when in fact, they don’t know what they don’t know and indeed don’t know enough to make that call. The degree to which people deny or belittle the importance of psychology in trading is the same degree to how much more effort they need to put into developing and improving their trading mindset to achieve trading success.

I have found amazingly that:

• the more successful a trader is, the more effort he/she continues to put into improving his/her trading mindset.
• the less successful a trader is, the more effort he/she puts into analysis or searching for tips, believing that the answer to success lies in cracking the right set of indicators and settings or right tipster.

In fact, the inner game of the trading process is

• making your focus that of acquiring the skills of consistency and objectivity.
• having an image in your mind of trading as an ongoing journey of acquiring these skills and improving these skills.
• accepting that your trading focus is not profits. Making profits is a by-product of this skills acquisition process. You may have heard other traders say, “detach yourself from the money”. Let’s put it another way. Detach yourself from the result or outcome of each trade. You achieve detachment by focusing on the process and how well you execute the process.
• enjoying the process of gaining and improving the skills of consistency and objectivity. Enjoy the challenge of this process and you will enjoy trading.

Don’t focus on the outcome, focus on and execute the process. The degree to which you focus on outcomes will be the degree to which you will be unsuccessful in the market. This is a trading paradox we’ll investigate further in next week’s blog.