CUTTING LOSSES VS. HOLDING LOSING POSITIONS IN A BEAR MARKET

INTRODUCTION
It is not uncommon in anecdotes and in our personal experience for some traders to continue to hold losing positions in a downtrend. I am sure they have compelling reasons, although very few have successfully elucidated them enough to be clear to many. This treatise will attempt to identify and clarify the issues that unfairly justify such a flawed trading plan causing a lot of financial and emotional grief to those who are similarly situated.

This isn’t intended to make people change their views about holding losing positions, although that is desirable, but merely to make them aware that there is a better option, so they can then weigh their choices. It is also important to note that knowing the other option (cutting loss) is not enough, since execution is the more difficult part entailing technical ability to a small extent, and demanding stiff emotional discipline. But just the same we have to start somewhere.
Before we can proceed with an orderly discussion, we need to mold the ground rules and agree to accept certain principles. This will qualify the traders who will be interested in the subject matter.

BASIC PREMISE OF A LOGICAL STOCK TRADE
1. The primary objective of a stock trader is to preserve trading capital and to earn and maximize profits. (For simplicity, investing and hedging strategies thru options and derivatives are not included within the scope of this discussion.)
2. For the purpose of attaining the above objectives, a stock trader will
a. buy a stock today if he expects the price to go up in the near foreseeable future.
b. hold on to a stock today if he expects the price to continue going up in the near foreseeable future.
c. sell a stock today if he expects the the price to go down or sideways in the near foreseeable future.
3. A trader has no other compelling reason to buy or sell a stock except those stated in (1) above. This rules out buying/selling stocks for other purposes i.e.
a. to gain management control of a certain company,
b. to attain or support certain artificial price objectives also called ramping or dumping or
c. to satisfy a person's psychological needs (e.g. risk taking, thrill seeking, or overcompensating for one's insecurities).

If you happen to agree with all 3 premises above, then read on. If you don’t, I suggest you find something else to do like check your email or something because it doesn’t apply to you and it will likely ruin your day.

COMMON RATIONALE FOR HOLDING ON TO LOSING POSITIONS
Now that we have set the parameters of this discussion, let me begin by paraphrasing (i found it necessary because most chat and forum postings are cryptic and abbreviated) the common remarks made by people who (a) initiated trades with a short term view, (b) subsequently suffered what they deemed to be serious losses and (c) consciously chose to hold on to their positions instead of cutting losses early (d) inspite of their near term expectation that prices will continue to fall.

1. "the size of my loss is huge, so I will just hold on to my losing position as a long term investment." (reclassifying time horizon)
2. "the size of my loss is huge but i cannot bear the pain of taking the loss, so i will just hold on to my losing position." (emotional)
3. "the size of my loss is huge, but its only a paper loss anyway, so i will just hold on to my losing position." (denial)
4. "the size of my loss is huge, so not only will i hold on to my losing position but i will continue to buy more in order to average down." (fighting the market)

Notice that each statement is preambled by the phrase "... the size of my loss is huge" followed by a specific course of action "... so i will hold on to my losing position". It would appear that the act of "holding on" is a consequence of attaining a significant level of loss. In some cases, other reasons are added i.e. "... i cant bear the pain", "... its just a paper loss".

A sound trading plan, when reduced to its very barest, is simply an action in the present tense (buy/sell/hold) based on a price expectation in the future (higher/lower/unchanged). If you parse all of the 4 statements above, it is clear that not one contemplates holding a position based on future price expectations. On the contrary, all of them are premised on an event or fact that has already happened i.e. "I already incurred a huge loss."

IT LOOKS LIKE A VALID TRADING PLAN
However, i do not for a minute believe these people to be naive. So let me continue paraphrasing by adding the phrase "... because i expect the stock price to recover sooner or later" at the end of each of the 4 statements above. Therefore, we finally reduce all of the 4 statements into 1 universal statement i.e. "I will hold on to my losing position ... because i expect the stock price to recover sooner or later". At a quick glance, it appears to be a sound plan i.e. hold now and sell later when the price goes up (even if the stock price is falling in the meantime).

DOES IT MEASURE UP TO THE BASIC PREMISE
Upon closer scrutiny, we find that it doesn’t fit squarely into any of the stated premise. For example, Premise 2.a. "buy a stock today if he expects the price to go up in the near future" matches the expectation of the price going up in the future (although the time frame is also suspect: sooner or later vs. near future) but is really intended for a buy and not a hold. On the other hand, Premise 2.b. "hold on to a stock today if he expects the price to continue going up in the near future" matches the plan of holding but is really intended for bullish expectations (near term rising prices) which runs contrary to the bearish scenario (near term falling prices) which we are contemplating.

Going by the parameters upon which this discourse was opened, then we can at this point rest and say that the validity of holding a losing position in a downtrend is busted.

DEBUNKING MYTHS.
But that would be too easy and anticlimactic. I’m sure you’re expecting nothing short of a full blown circus show even for the sake of mere entertainment. It’s in our nature to question and not merely submit to seemingly dogmatic assumptions, even if it was previously agreed upon (remember PIATCO and AMARI). So let’s be indulgent and size up this controversial trading strategy on its own merits. Let’s review the facts so everything will be clear and fresh in the ensuing arguments. The situation contemplated is that a huge loss has already been incurred, and the price is expected to continue falling in the near term.

a. "It’s just a paper loss." This is my favorite, but it always makes me want to go to the toilet. A trading loss is a loss, period. Prefixing it with the word "paper" doesn’t push your portfolio into a profitable or breakeven position. We are stock traders and when we value our portfolio, we mark to market. Let’s leave the creative accounting methods to the accountants of Enron, Worldcom and Tyco. Besides, even if its a paper loss, remember that you expect the price to continue falling in the near term, so does that mean you will be willing to take on bigger piles of paper losses with no relief in sight? If by a long shot your answer is yes, then let me remind you that most sane people trade stocks to make money. Oh, and another thing, if its just paper, why do most traders feel despondent when they are saddled by huge paper losses and why do the same people experience multiple orgasms when they accumulate tons of paper profits? They're both paper - hello!

b. "I can’t bear the pain of taking a big loss" and "Its too late (baby now its too late)." Reminds me of Carole King's love song to James Taylor when they broke up, but I digress. Anyway, so what do you do? Keep on taking losses? The big eventually becomes huge. The huge eventually becomes humongous. And your previously large capital is now shrinking to oblivion. (Try substituting the word "penis" for "capital" in the previous sentence and then you can imagine the resulting grief and loss of confidence that you are bound to experience. For the females who can’t relate use "breasts" instead of capital.). Think it through. Is that what you really want? If you say yes, meaning you’d rather opt for increasing your losses instead of biting the bullet by selling and cutting loss, then give me a few seconds to pick myself up because i will surely fall off my chair. What can I say, except that maybe stock trading is not for you because there is no way in heaven or hell for a stock trader not to experience taking a loss in the span of a serious trading career. Traders who survive this challenge, learn that they will make mistakes in the future and in spite of the accompanying pain, will act on those mistakes by cutting losses early.

c. "I will average down." If you’re completely aware that the stock price is expected to continue falling in the near term, and you’re still dead serious about this, I’m sorry but i have to strongly recommend brain surgery. Averaging down only reduces your average cost per share, but since you’re adding on more shares, your total loss amount is still actually increasing. Remember the situation we are faced with - price is expected to continue falling in the near term - I'm sorry but there is no mathematical possibility that averaging down will ever yield you a profit in that context.

THE SERIOUS CONTENDER
d. "The stock price will recover sooner or later." Haha. This is the culprit, the jackal, the snake oil salesman of all losing positions because it sells hope. It remains the only serious argument for holding on to losing positions because it is based on future expectation - that the price will turn up eventually. As i mentioned earlier, i suspect that the same conditionality is implied in a, b, and c above. The serious flaw, however, lies on the vagueness of when it could happen i.e. "sooner or later".

1. If it happens later, so what? So what? Here's two. Unnecessarily enduring increasing capital drawdowns and opportunity loss. Since prices are expected to fall in the near future, you’re exposing your capital to further drawdowns while waiting for the much ballyhooed recovery entitled "sooner or later". In other words, it will get worse before it gets better. If a bearish period is expected in the future, what’s keeping you from closing your position now, and in the meantime (a) hold cash, or (b) buy a different but uptrending stock, or (c) invest in fixed income risk free securities - while waiting for the recovery of your favorite stock.

2. If it comes sooner, what now? What now? Is there a law against buying back in? In the off chance that price begins to trend up immediately instead of the expected continuing downtrend, and the trade offers a favorable risk reward potential, why not buy back into the stock? Additional transaction fees? That’s a measly 1.1% on a 2-way trade. We usually open positions with profit targets way above that figure. Responsible traders spend lots of time identifying setups with favorable risk reward potentials. You should too.

THE WINNER: CUT LOSS EARLY
Not convinced? Push the pencil! I know I did. In a normal bottoming out where the absolute slope of the downturn is equal to the slope of the recovery, you will see that if you cut losses early enough you will avoid severe capital drawdowns, and if you intend to buy back upon recovery, reach breakeven point a lot quicker and post bigger trading profits