Market Psychiatrist Dorn: "Why Are Traders Addicted To Perfection?"

I recently came accross this excellent article about trading psychology and decided to share it.

Market Psychiatrist Dorn: "Why Are Traders Addicted To Perfection?"
MARKETS, STOCKS, COMMODITIES, PSYCHOLOGY
Posted By: Janice Dorn |
| 27 Jan 2009 | 09:00 AM ET

Trading is not about perfection. It is about probability and progress.

All charts, analyses (fundamental and technical) and trading plans are built on probabilities.

Why then, do so many traders strive for perfection?

Why do so many traders miss trades, waiting for exactly the right entry, beat up on themselves when it doesn't come and the position runs away while they sit there scratching their heads and condemning themselves?

Why are so many traders trying to turn a game of probability into one of near-perfect certainty?

The answer lies in one of the cardinal sins of trading which is PERFECTIONISM.

Perfectionism can be a great help to people in many professions, but can be fatal to a trader. Perfectionists, always trying to find the Holy Grail of trading go from one service to another, from one system to another, looking for a way that they can be right all the time. “YES! Now, I found it! It’s this trading room, or this service, or this indicator! Uh-Oh---Wait... something is wrong here. Not all of these trades are working and I have drawdowns! How can it be that this particular method failed and I actually had to take a loss? Must be something wrong. I will try harder and look for an even better system, a more expensive service, a new and improved guru, some absolutely no-fail software so that I can have ONLY WINNING TRADES.”

This is perfectionism in action. Not only does this type of irrational behavior and belief undermine and demoralize a trader, but it takes away all the enjoyment and fun of being in the markets. It leads to depression with depletion of psychic and physical energy, and leaves the perfectionist to confront his basic and overriding fear — fear of failure. In the extreme, it leads to physical and mental illness, including addiction to prescription drugs, alcohol, or illegal substances as well as other addictions. The pain of failure or the haunting fear of failure is simply overwhelming, and one turns to whatever works to medicate the pain.

Life can be lived forwards, but can only be understood backwards...Soren Kierkegaard

This is what happens with perfectionists. Perfectionists are made, not born. We are taught from an early age by demanding (and often well-meaning) parents that we have to be the best in order to win their approval and the approval of others. Unfortunately, this is totally upside down. Perfectionists share a belief that perfection is required in order to be accepted by others. The reality is that acceptance cannot be gained through performance or any other external factors. Self-acceptance is the root of happiness and the true beginning of personal evolution.

If you have a perfectionist mentality when trading, you are setting yourself up for failure, because it is a "given" that you will experience losses along the way. You must begin to think of trading as a game of probability. Your losses (that you hope will return to breakeven) will kill you. If you cannot take a loss when it is small ( because of the need to be perfect), then you will watch that small loss grow into a larger loss and so on into a vicious cycle of more and more pain for the perfectionist. Trading on hope does not work, because the markets can be “wrong” for a lot longer than you can remain in positive cash flow. The object should be excellence in trading, not perfection. Moreover, it is essential to strive for excellence over a sustained period, as opposed to judging that each trade must be excellent. This is a marathon...not a sprint.

The greatest traders know how to take cut losses and let winning positions run. Perfectionists often do exactly the opposite.

They get in at the wrong time, stay in too long and then get out the wrong time. Perfectionists are always striving and never arriving. The market will find the flaw in a perfectionistic trader and exploit it day after day. The market is your greatest teacher and your most demanding critic, so take this wonderful opportunity every day to learn about yourself and make yourself strong.

If you see in yourself this trait of perfectionism rearing its ugly head, it's OK to get angry at it and even yell or curse at it. Do whatever it takes to acknowledge it and then find a way to fix it.

Here are a few suggestions:

Try to appreciate and enjoy the process as well as the outcome
Set more achievable and realistic goals for your trading
Remember that your self-worth and your worth as a human being to those who love you does not fluctuate from day to day depending on if you win or lose that day
Focus less on achievement and more on enjoyment. Trading is serious, but it should be fun and not something one approaches with fear and dread
Lighten up. Laugh more (especially at yourself!)
Learn from your mistakes, forgive yourself and make peace with your past. Strive to be better...not perfect...just an amazing human work in progress.
If we were always to wait for the most favorable combination of circumstances, no enterprise would ever be undertaken. There can be no end without a beginning--there was never an enterprise in which everything fitted in perfectly, for chance plays a leading part in the affairs of all men.

Obedience to rule does not ensure success, but success, on the other hand, furnishes a canon---a rule of conduct...Napoleon Bonaparte

Thanks and Good Trading!

Janice
_________________________________

Janice Dorn, M.D., Ph.D., is a financial psychiatrist and chief global risk strategist for Ingenieux Wealth Management in Sydney, Australia. She also offer trading consulting and coaching services via her Web site, TheTradingDoctor.com.

URL: http://www.cnbc.com/id/28872487/

MARKET BOTTOMS

Everbody i know and their pets appear to be too preoccupied with market bottoms. So here are a few articles about this very elusive market phenomenon. Personally, I look for reversals, not bottoms. But here goes.

*Daryl Guppy: Identifying Capitulation: How to Tell We've Hit Bottom
*Tech Ticker: Does Lack of Bottom Calls Signal a Bottom?
*Cramer: How to Call a Bottom

DJIA, CRITICAL SIGNALS LEADING TO A REVERSAL SCENARIO

A hypothetical reversal scenario of the Dow indicating the technical signals that forewarn each stage as they unfold. This is an application of the typical reversal patterns that I posted earlier [Thursday, April 3, 2008|BOTTOMS AND REVERSALS] and a follow thru to my article about spotting reversals and continuations [Sunday, April 20, 2008|DJIA, SPOTTING REVERSALS, CONTINUATIONS AND CONSOLIDATIONS] . The appearance of a higher low in the primary trendline constitutes a provisional major uptrend. A 2nd higher low confirms the major uptrend and the existence of a bull market. A bull market exists when the primary trend is advancing.

DJIA, SPOTTING REVERSALS, CONTINUATIONS AND CONSOLIDATIONS

Here's an uncomplicated view of how the Dow in its current state can unfold into a reversal pattern, a continuation pattern of the prior downtrend or a drawn out consolidation. A pair of similar looking yet notably different reversal scenarios of the declining Oct-2007 trendline are presented. Both are Inverse Head and Shoulders formations that come with failure patterns. The discrepancy lies in the sequence of how they unfold. In the first reversal figure - indicated in black - the trendline break occurs before the failure pattern. The other reversal configuration - indicated in green - shows the higher low occuring before the trendline is broken. There are other possible reversal patterns not shown here. The important thing is knowing most, if not all of them, and how they unfold in varying fashion. Equally important is being conscious that as the 2 patterns illustrate - a reversal is not an event. It is a process or a series of events that need to transpire over a period of time before they can be correctly declared as such in the context of technical analysis. This awareness keeps technicians patient and focused - hopefully able to spot new trends in early stages, more often than not putting themselves in a fairly good position to catch relatively big portions of the directional tendencies. For general reference, the typical entry points of trend followers are also indicated in the chart.

PSEi 4/9/08 PHILIPPINE STOCK MARKET TECHNICAL ANALYSIS

OUTLOOK
The local composite index drops another 19pts on moderate volume. It opens just about even and declines until the end of trading hours. There's nothing much to say about today's chart except that the stock average is trending down in an orderly fashion. The peaks and troughs of the trend coincide almost perfectly with the extreme swings of the stochastic indicator. The intermediate trend exhibits a textbook "left translation" that is typical in declining cycles where the duration of impulse waves (downlegs in a downtrend) last longer than the corrective waves (correction rallies in a downtrend). This "well-behaved" descending trend also provides a convenient example for the application of the Elliot Wave Principle(EWP) where one could argue that the last trough in mid March-2008 is the #5 wave of a downtrend that started in Oct-2007 and therefore a 3-wave correction to the upside should follow shortly. It will be interesting to see what happens from an EWP perspective. In the meantime, invoking the Dow Theory's tenet that a trend is valid until proven otherwise, the measured move method yields a potential price objective of 2,500.

PRICE AND TURNOVER
Close: 2,961.78 * Change: -19.34 (-0.65%) * Value: 2,548,138,000

MARKET BREADTH
Net Adv Issues: -66 * Net Foreign Buying: -221,521,264 * Net Up Volume: -367,367,750

TECHNICAL ANALYSIS
Major consolidation * Intermediate downtrend * Minor downtrend * Support 2800 * Resistance 3000 * Price objective of current downleg 2500 * Double top on the weekly chart

BOTTOMS AND REVERSALS

DID WE HIT BOTTOM? * ARE WE IN A REVERSAL? * WHEN CAN WE START BUYING? * WHAT SHOULD WE BE LOOKING FOR? I get to field a lot of these questions lately, and with good reason, considering the present market environment where the major trend is ambiguous and the shorter trends are all over the charts. It just shows there are a lot of thinking heads out there seeking answers before committing a position, and I admire them because they are asking the right questions. To those who practice technical analysis, the answers may look fairly obvious and straightforward. But just the same, I put together a few diagrams that ought to show how technicians customarily visualize a changing downtrend. They are illustrated in a general and overly simplistic manner but I find them extremely helpful nonetheless. The real deal comes with a lot of chart noise and clutter. As a stock trader using technical analysis, i would like to see any one of reversal patterns A, B, and C.1 appear before I start participating. And although I wouldn't be buying into consolidation pattern C, I would absolutely welcome seeing one unfold as it is a sign of a potential bottoming that could precede a subsequent reversal such as C.1.

PSEi 4/2/08 TRENDLINE BREAK ... CHANGING TREND

The local index gaps up at the open and advances to close +2.6% near the high. Turnover is above the 15-day MA. At this level, the index breaches the intermediate downtrend line. This is significant because a trendline break is usually an early signal of a change in trend. But a trend change is not a straightaway synonym of a reversal. A change in trend could mean any of the following: (a) a reversal of the current up or down direction-the most common notion, (b) a switch from a directional to a non-directional tendency otherwise known as consolidation or sideways movement, or (c) a shift in the slope of the current directional trend which is merely an acceleration or weakening of speed or momentum. With these in mind, we must resist the temptation to anticipate or jump to conclusions prematurely. We need to wait for further signals to show us in what direction the new trend is heading before we can chart an appropriate trading plan. It is valuable to be able to distinguish which signals are actionable versus those that merely clues us in to a potentially significant and imminent price movement.

PRICE AND TURNOVER
Close: 3,048.31 * Change: +78.48 (+2.64%) * Value: 3,488,681,000

MARKET BREADTH
Net Adv Issues: 62 * Net Foreign Buying: 139,783,743 * Net Up Volume: 306,428,270

TECHNICAL ANALYSIS
Primary consolidation * Secondary downtrend * Short term uptrend * Fib retracement (38.2%) 3,000 * Prior Support 2,800 * Prior resistance 3,300 * Potential trendline resistance 3,000 * Potential (role reversal) resistance 3,000 * Broken intermediate trendline.

DGTL 4/1/08 BREAKOUT FADEOUT

DGTL gives back 75% (0.12) of yesterday's 0.16 advance settling 0.02 below 1.60 - a level that we have seen reverse its role from acting as support in Jan-2008 and subsequently as resistance in Feb-2008 and Mar-2008. The stock's decline is as steep as yesterday's advance except that today's volume is noticeably lighter at only 701,000sh. Yesterday's volume is 14,842,000sh - over 21x today's accompanying turnover and close to 9x that of the 15-day MA - supporting the validity of the breakaway move. However, it is price, not volume, that ultimately matters, and I will be hard pressed to find a more illustrative example of this object lesson than this recent 2-day extreme turnaround. The more aggressive trader would have entered yesterday during the frenzy, and the less risk tolerant would have waited for a continuation signal today before participating. That is not to say that one technique is better than the other because there are obvious trade-offs between the 2 systems. The aggressive trader stands to be stopped earlier with a small loss in case the breakout fizzles but if the advance prospers, he gets to capture the bigger portion of the up move by participating earlier. By waiting for a second day confirmation, the risk averse trader avoids taking a premature loss in case a quick fade out occurs but if the breakout promptly catches fire he gets to climb on board a bit later in the move sacrificing the early portion of the advance. In any case, I will be looking closely at the critical level of 1.60 and whether (a) another role reversal is in the offing that could provide a base from where the stock price stabilizes and continues its advance or (b) it continues to act as resistance that sends the stock re-entering the confines of the 1.42-1.60 trading band. For those who participated yesterday, the focus of the trade now shifts to risk management and swift execution of stops in case a range pattern re emerges.

PRICE AND TURNOVER
Close: 1.5800 * Change: -0.1200 (-7.06%) * Value: 1,117,800

TECHNICAL ANALYSIS
Primary trend undefined * Intermediate uptrend * Short term consolidation * Prior support 1.42 * Potential support (role reversal) 1.60 * Resistance 1.84 * Faded breakout of 3-month range * Potential price objective of breakout move 1.84

* Personal Disclosure: I own a trivial number of shares of DGTL.

MARKET BREADTH INDICATORS

I've added a new set of indicators in the sidebar from StockCharts.com - "NYSE Market Breadth". They give us a sense of whether the NYSE stock market as a whole, composed of over 3,000 listed issues, is moving in tandem with the Dow Jones Industrial Average, an index composed of only 30 stocks. This follows the "PSE Market Breadth" indicators that I put up a few weeks earlier. I had to construct the PSE breadth charts myself since I couldn't find any from the PSE, online brokers, and local stock market related websites. These will be updated every weekend.

BOOK ORDERS

I ordered the ff books from Amazon.com to add to my library on technical analysis. ETA is Apr-7 to Apr-11. They should keep me occupied while I am waiting for this downtrend to bottom out.

• "Point & Figure Commodity & Stock Trading Techniques: Commodity and Stock Trading Techniques Also Options-Bonds-International Currency-Indices" Kermit C. Zieg
• "Channels & Cycles: A Tribute to J. M. Hurst" Brian Millard
• "Fibonacci Applications and Strategies for Traders" Robert Fischer
• "Elliott Wave Principle: Key to Market Behavior (Wiley Trading Advantage)" A. J. Frost
• "Forecasting Financial Markets: The Psychology of Successful Investing" Tony Plummer

MY BOOKS

Earlier today during trading hours, a member of the p6chat community asked me for a list of my book collection on stock trading and technical analysis so I created a new section in the lower right hand column of this blog "MY BOOKS". Over a period of three years, I've read each one at least twice. I am sure I missed one or two titles but I will promptly add it to the list as soon as I remember where I last saw them.

If you are looking for a quick fix, I am telling you early on that you won't find it in any one book. If your objective is to develop a trading system that offers a healthy, consistent, long run, aggregate, net trading profits (total profits minus total losses), these books will surely help you think, plan and go about building one. The appropriate system will have to come from a combination of studying, self-assessment, developing, experimenting, tinkering and a healthy dose of experience. But that's the easy part. The issue of discipline-sticking to and following thetrading system that you choose to use-is the more important part. This is solely and exclusively supplied by the student thru determination, resilience, and single mindedness, with the accompanying (not optional) mixed emotions of pain, frustration, fear, hope, greed, elation, triumph, exuberance, and sometimes depression. Pay attention to these emotions. You can learn a lot from them.

Most of these book authors say, and I agree, that if at all, striving to be a successful stock trader is a continuing process, more like a journey. It never stops. The world changes, markets change, and the successful trader must be able to tweak his system in a timely manner to adapt to the new challenges as they come.

Good luck to those who plan to buy and read the books. I sure hope you learn a lot quicker than I did. I know I had a tough time learning.

WHY WAITING FOR AN UPTREND IS IMPORTANT

Now may be a good time for technical traders to reinforce their thinking about why trading in the direction of the prevailing trend is considered the major underpinning of technical analysis in the pursuit of consistent, long run, aggregate, net trading profits. Following are some issues raised by John Murphy. Let's see what he says.

"The concept of trend is absolutely essential to the technical approach. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends."

"The entire trend-following approach is predicated on riding an existing trend until it shows signs of reversing."

"In a general sense, the trend is simply the direction of the market, which way it's moving."

"The fact of the matter is that markets actually move in three directions-up, down, and sideways. It is important to be aware of this distinction because for at least a third of the time, by a conservative estimate, prices move in a flat, horizontal pattern that is referred to as a trading range. (So in a market like ours, where short selling is not allowed by the local stock exchange-contrary to the unfounded claims of a few who insist that it is-long trades are bound to be unprofitable two-thirds of the time.)"

"There are three decisions confronting the trader-whether to buy a market(go long), sell a market(go short) (again, not allowed by the local exchange), or do nothing(stand aside). When a market is rising, the buying strategy is preferable. When it is falling, the second approach would be correct (ditto-not in our market). However, when the market is moving sideways, the third choice-to stay out of the market-is usually the best."

"Most technical tools and systems are trend following in nature which means that they are primarily designed for markets that are moving up or down. They usually work very poorly, or not at all, when markets enter these lateral or "trendless" phases. It is during these periods of sideways market movement that the technical traders experience their greatest frustration, and systems traders their greatest equity losses. A trend following system, by its very definition, needs a trend in order to do its stuff. The failure here lies with the trader who is attempting to apply a system designed for (following) trending markets into a nontrending market environment (or trading against the prevailing direction of the trend)."

(*Annotation in italics and bold emphasis supplied by Whipsaw.)

BEAR MARKET, DEFINED

The recent serious declines in the Dow Jones Industrial Average has started TV commentators, financial analysts, fund managers, and even individual traders alluding to the term "bear market". I'm sure everyone including the neighborhood stray dog has heard and even used the term "bear market" when talking about stocks . But did we really bother to get to know what the authoritative definition is or if one even exists? Well, I did ... just about 2 minutes ago... (lol). I dusted off my books and pored over them looking for a definition and these were all that I could find.

• "A bear market is an extended period, usually lasting somewhere between 9 months and 2 years, in which most stocks decline most of the time." --Martin Pring, Technical Analysis Explained, (New York: Mcgraw-Hill) 353

• "Major Trend Phases ... 7. The Bear Market - Primary downtrends are usually characterized by ..." -- Edwards and Magee, Technical Analysis of Stock Trends, (Boston: John Magee Inc.) 20-21

I also browsed thru the glossary of StockCharts.com and found the following.

• "Bear Market: A long period of time when prices in the market are generally declining. It is often measured by a percentage decline of more than 20%." --http://stockcharts.com/school/doku.php?id=chart_school:glossary_b#bearmarket
  

I did run into other definitions that invariably added certain qualifiers such as i.e. "stock prices retreat by a stated percentage (i.e. 15% to 20% in some sources), is accompanied by an economic recession, investor pessimism is prevalent, etc"... but i didn't bother quoting them as they failed to provide any worthwhile source or citation. Apparently, there is no strict definition of the term "bear market". I found out that most people have slightly differing notions of the phrase but the conventional understanding is that in bear markets prices of most stocks are declining in serious fashion. So choose which one suits you. I'll stick to mine ... a bear market is when the broad market index is in a primary or major downtrend.

TREND ALIGNMENT: The Simple Logic Behind It

I think it was at the p6chat xmas party last Friday when a couple of guys asked me when i intend to resume participating in the stock market. Of course my boring reply was "when i see the market resume a clear and strong uptrend". Now why do I, as well as many other traders who trade with the trend, find this important? The answer is because if I align my long trades with an uptrend, I am stacking the odds in my favor so that most of my trades will be profitable.

You see, in an uptrend, the sum of the rallies are larger than the sum of the declines in prices, this is a fact, period, end of story. Mathematically, this phenomenon accounts for the positive slope of the uptrending price action. Using this simple observation, there are certain generalities to be gleaned in the characteristic of price action during an uptrending environment. Since trends appear in the price charts, which are 2 dimensional, these generalities will be limited to the variables of time and price which corresponds to the x and y axis. The logical expectations are: (a) in an uptrend, odds are in favor of each rally being bigger than the ensuing correction (b) in an uptrend, odds are in favor of rallies occurring in longer duration than the declines (c) if an index is in an uptrend (notwithstanding some component stocks weighted heavier than others), odds are in favor that there are more component stocks in an uptrend rather than otherwise.

So there you go.. each time I open a position in an uptrending environment - the odds of a, b, and c, above are all working in my favor. Now that doesnt mean that I will be making money all the time (THATS WHAT PROTECTIVE STOPS ARE FOR), but it surely allows me a heightened sense of trading confidence knowing that my trades stand a good chance of being in the money. It also doesnt mean that there are no profitable trades to be made in a downtrend or consolidation - there may be a few, but they are considered high risk since the odds are not in my favor. Remember - there's no sure thing in the stock market. So wouldnt you want the odds to be in your favor when you trade?

More on trends and other building blocks of technical analysis next time .. Cheers !

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