Revenge Trading

Today, our Head Trader, Robb Reinhold, answers a question from one of Maverick's traders about jumping back into a trade after being stopped out.*


-----Original Message-----

From: Stephen K.
Subject: Today's trade

I see that [on June 1, 2015] you shorted the GBP/USD @ 1.5227. Then, I assume it didn't follow through on the downside. Stopped out at break-even.

Do you ever consider re-shorting coming back through 1.5227, provided it didn't hit the original stop?

I see its @ 1.5202 now. You would be profitable right now. I'm guessing the risk/reward ratio changed due to the original lack of follow through. Just trying to see your thought process.

Thanks,
Steve


-----Reply Message-----

Hi Steve,

This is a great question and really gets to the heart of trading and a trading plan. When you get knocked out of a position due to some volatility, it is very human to want to get back into the position when/if it starts going the way that you originally thought – or to even enter the opposite trade! You already put in the effort to analyze it, you watched and spent some of your valuable time during the trade and now it's looking like it is working just like you analyzed.

So, why not just jump back in? Let me give you a couple reasons…

As you have heard us say time and time again, trading is 10% technical and 90% mental. The hardest part of this business is learning how to eliminate your mistakes, control your emotions and follow a trading plan consistently every single time.

Over my career, I feel like I have fallen into most of the pitfalls of trading and I feel compelled to tell my stories to our traders so they hopefully won't have to fall into as many as I have. One of my favorite things to make fun of is what I call "Revenge Trading."

Revenge Trading is when you take a bullish position and the trade works against you for some reason. You watch the price action and it becomes clear to you that got your analysis wrong and the position is going against you, causing you losses. So, you get knocked out of the position or exit the position for a loss. Then – sometimes within minutes! – you decide that you will now take a bearish position and make all your money back! It's so clear to you now that the position is moving lower.

The problem is that in moments of a blow-off top or capitulation bottom, the price action is so strong that it looks like a sure thing. However, we know that this is when bottoms/tops are typically created – where the last of the longs panic and sell or the stubborn shorts finally capitulate and cover.

Here is the problem with this trade: It all comes down to capital allocation. Capital allocation in trading is the concept where you are constantly analyzing and deciding where the best place/trade to put your capital at work will be. It comes down to which situation has the best reward for the least amount of risk.

In the situation above, the trader is ignoring all other possible trades and they are locked into this one (1) position. If they just waited for an hour or so, my guess is they would find a trade that offered an even better risk/reward than the one they just exited. However, because of the time they already invested in analyzing and watching it, they will be emotionally drawn back to the trade.

In your example, the trade was stopped out at break-even and is now starting to move the way we originally thought. My rule (and I think ALL traders should adopt the same rule) is that once a trade is closed, then treat it as if it never happened. It's the main reason why I do NOT have a "watchlist" of positions that I look at on a periodic basis.

I start at the beginning of every week/trade with a total clean slate with no preconceived notions of what is going up or down (or at least I try to as much as possible). If there was a good potential trade that I found last week that did not trigger, then it should show up again next week as a good trade when I do my new analysis. In this manner, I am trying to look at the market fresh and not have any of my biases from last week that could cause me to get "tunnel vision" (where I only focus on a small number of trades).

So, in this trade that we entered short, moved our stop to break-even and ultimately got stopped out, I would forget that it ever happened. Go back to the beginning and go through your analysis of the markets, relative strength/weakness and chart analysis. If it is still truly the best trade to allocate capital, then it will show up again in your analysis. However, my guess is that you will more often find a better trade that offers better potential reward with less risk.

To sum it up: The more you can completely forget about a closed trade, the better you will be as a trader.

Thanks,
Robb


* NOTE: Some original wording has been slightly modified for legibility.