The break-even fallacy

Chart Forum » Trading - Psychology » The break-even fallacy

«« Previous Next »»

Thread Start New Thread
Last Poster Posts Pages Last Post

Author

Message

david_louisson

Member

Post Number: 220
Registered: 02-2004

Rating:
Votes: 1


Sunday, March 05, 2006 - 06:14 pm:

Possibly one of the bigger mistakes made by inexperienced traders is that they move their protective stop too hurriedly to the break-even point.

As an example, suppose a trader enters at $10, with the protective stop at $9.70. Then when costs are covered as the price hits $10.10, he immediately moves his stop to $10.00, so that (slippage apart) he can not lose. In other words, price has moved only 10c, but he has advanced his stop by 30c.

IMHO, this is an error. If there was a valid reason to trail the stop by 30c at the entry point, then it is unlikely that volatility has changed sufficiently to justify suddenly tightening the stop to just 10c below the current price.

A better option would be to move the stop to $9.80, or (when appropriate) to just below the next swing low. Whatever the rationale, the reason should be a technical one, as opposed to simply averting a losing trade.

As a wise man once said "it's not how many trades you win, but how much you win". Or, put another way: it is neither more nor less valuable to lock out 10c worth of loss than it is to lock in 10c worth of profit, as each ultimately has an identical effect on eventual bottom line. But somehow, fear of loss gets in the way, and we do not see this clearly.

Unduly tightening a stop increases the risk of being stopped out prematurely, with the "double whammy" effect that not only was a winning opportunity squandered, but a loss is incurred in its place. It violates the maxim of letting profits run. Of course one can always re-enter the position, but that means incurring a second set of costs.

David