Sunday, June 22, 2008

The mother of all losses

Jack Schwager's book "The New Market Wizards" starts with a chapter titled "Hussein makes a bad trade". The story is of Saddam Hussein who took a calculated gamble by capturing Kuwait, but did not know when to get out by accepting that the trade was not paying off. In the end, he lost the war.
Schwager finds a moral in the story: If you can't take a small loss, sooner or later you will take the mother of all losses.
Good traders know this principle. In fact, taking small losses is the foundation stone of trading.
Let us look at the Indian Markets. The Nifty has fallen from a peak of 6350 in January 2008, to a low of 4345 on June 20, 2008. This is a bear market by any definition. Many traders who try to fight the down trend by retaining long positions are losing a lot of money. One reason they cannot close their positions is this: Suppose I sell today and close my position, then it turns out that today was the final low of the bear market. In this case, I would have capitulated at the worst possible time.
This reasoning ensures that a small loss becomes the mother of all losses.
One simple trading pincinciple that emerges is: always cut your losses.
The second question is: Should I sell today ? An asnwer to this question will help the trader to take a decision. The asnwer in fact is already available in the opening paragraphs of this column, where I state that this is a bear market.
But, the real question is something else. It goes like this: Sudarshan, I trust you. I listen to you regularly on CNBC-TV18 and I appreciate your straightforward comments. You tell me that I should sell out, and, I will immediately do so.
Implicit in this question is: Give me an assurance that prices will fall further after I sell.
Now, this is not possible. No one can forecast the future with a guarantee. This is a decision that traders have to take on their own.
I can again state the basic principles:
If you have trading positions that are losing money, you should get out immediately.
For your investments: Switch from low grade, momentum stocks to high grade blue chips. If you have any loans on your investments, sell out to the level where your investments are made with your own money. Do not carry leveraged positions in your investment portfolio. Take the loss.