By Jon Najarian, Mercury Trading
Back in the 1980s, the Japanese claimed to have eight of the top ten largest banks in the world. It wasn't just their deposits that pumped up those balance sheets, it was an accounting peculiarity that allowed Japanese companies to value assets for the price they were purchased for, not the fair market value. Simply put, they may have paid $400 million for an office complex two years ago that would fetch just $200 million today, but the bank needn't take that embarrassing $200 million hit, as it could and did still count the purchase price as the "value" of the property. A strange practice to be sure, but millions of investors do the same thing every day of every year, unwittingly letting profits slip through their fingers.
As a professional trader for the past 22 years and as a mentor to many young traders and individual investors, I can tell you that the malady I'm about to describe isn't something which only individual investors struggle. It's something that everyone from the novice to the seasoned veteran has to deal with ? forcing yourself to forget what price you paid for your trade.
Whether I'm sitting in on a morning meeting with floor traders, or speaking to a crowd at an investment conference, invariably someone will say, "The CBOT mini-sized Dow was down 100 to 7900 yesterday, but that's OK, because I bought it for 7610 three days ago, so I'm still up."
They usually say this with a sense of pride, rather than embarrassment, perhaps thinking I will congratulate them on their shrewd purchase. Unfortunately for them, I don't applaud this behavior - I abhor it. It points out several weaknesses in their trading, not the least of which is their lack of understanding that every trade (investment) has an entry and an exit. Until you've actually closed the trade, you haven't booked the profit. If you make a timely purchase or sale of a security or futures contract, congratulations. In reality, you're only halfway home. You also need to capture that profit by closing out the trade. It doesn't matter whether you're bullish and your entry is a purchase, or whether you are bearish and your entry is a sale. You can't pop the champagne until you've cashed in your chips.
FORGET WHERE YOU GOT IN, IT'S WHERE YOU CASH OUT THAT COUNTS.
The other problem with this behavior is that the investor or trader remembers the entry price. That's a mistake because what you paid, or where you sold is of little consequence. What matters is where that stock, or commodity is right now. An opportune sale is wonderful, but where you cover that short position is eminently more important than where you established the position. When I'm looking at a portfolio, the last thing I care about is at which price the client established a given position. I care about the here and now, where I can buy or sell that asset this minute.
For example, the CBOT mini-sized Dow Futures may have been an extraordinary buy at 7600, but at 8000 would I think it still represents a value versus other investment opportunities? If my answer is that I wouldn't buy the CBOT mini-sized Dow at this level, then, frankly, why should I hold onto it? Isn't the answer that I should take my profit and wait until another long or short opportunity presents itself? Of course, that is the correct answer, but you'd be surprised to see how many people believe that they are "playing with the house's money," and these are the folks who either take smaller profits than they deserved or, worse yet, turn their winning trades into losers because they remembered where they got in rather than remembering that nobody ever went broke taking a profit!
When I ponder why individual investors have so much trouble with this concept, I have to blame the tax code and the IRS, which doesn't recognize a profit or loss for individuals until they close the trade. This policy has bred the mindless tax-loss selling that shows up every December, as investors scramble to recognize losses and match them against their gains. Professional traders are marked to market every day, meaning the profits and losses are right there in black and red, so it doesn't matter whether we close our trades or not.
Perhaps another reason some of us seem so reluctant to forget our entry price is strictly ego. We want to tell someone else how clever we were. It's more fun at a cocktail party to tell your neighbor that you shorted Gold at $381 an ounce when it has retraced the move back to $370. Unfortunately they are missing the point completely that those $11 in profit are not yours to spend until you've closed out the trade. Pro's trade in and out so frequently it's nearly impossible to remember every entry or exit price. For example, my brother Pete, a former NFL linebacker for the Seahawks, Vikings and Buccaneers, is a specialist on OneChicago<sup><small>TM</small></sup> for Single Stock Futures (SSFs). Pete may make 100 to 500 trades per day in SSFs, hedging with 100,000 to 1,000,000 shares of the underlying stocks. If he happened to buy the low of the day, or sold the top he may remember it, but not in relation to the corresponding stock or futures trade. The past is just that, history. What matters is where he can get in or out this second, assuming reasonable risk to reap acceptable reward.
Here's a tip for how you can break yourself of the habit of remembering where you got into a trade: Sit with a friend and swap portfolios. Let him or her go over your positions and, conversely, you examine his or her portfolio. Invariably, you will find positions that seem to be ripe for harvesting. I think you'll hear conversations that go something like this:
"Gee Mark, I notice you're still holding onto the IBM 80 ? 85 bull-call spread. It's trading for $4.55, so I don't really think you can justify holding on for two more weeks just to make that last $.45. If anything, I'm more a seller of that spread at these levels."
"Well sure, Judy, but I bought that spread back in late November for just $2, so I'm?.OK, I get your point. But since your brought it up, what about your butterfly spread in Sears? What are you waiting for?"
Professional traders and money managers go over their positions every day, which is probably too frequent for most investors reading this column. Most of you already have full-time jobs and you pay substantially higher commissions than the professional trading community does. Daily portfolio assessment is not only impractical with your time constraints; it may also cause undo churning of commissions, which would erode your profits.
You need to strike a balance between forgetting the price you established your trade and completely letting the market trade you. You should remember that investments in the stock or futures markets are not the same as making a bank deposit and leaving the money there until you need it. A prudent investment with good risk / reward ratio can turn into a terrible position, with horribly skewed risk versus reward in a very short period of time. Prudent traders and investors should keep the odds in their favor throughout the life of their trade, keeping their eyes on the prize, but weighing the probabilities and getting out when they've exhausted the edge they originally sought to exploit.
When you conquer the problem of remembering your entry price and instead focus on whether you should be in that trade at this level, you will truly be on your way to managing your risk and trading like a pro. If you insist on "playing with the house's money," one thing is for sure -- it will be the house's money again! Remember the problems with those Japanese banks. It's not what you paid for it. It's where the market is right now that matters.
Want to know more? Submit a question to the author of this article (please include "NajarianStrategy" in question).
Interested in other trading strategies?
<hr> About Jon Najarian
Jon 'Doctor J' Najarian is a Chicago-based money manager and the founder of Mercury Trading, a proprietary trading firm. He hosts a daily financial radio program called "Taking Care of Business with Doctor J," on CBS Radio AM 670, and his market commentary and money tips are carried on Fox television in the Chicago market twice every business day. Mr. Najarian is chief market strategist at www.ptisecurities.com, a securities and futures firm he co-founded in 1991.
Back in the 1980s, the Japanese claimed to have eight of the top ten largest banks in the world. It wasn't just their deposits that pumped up those balance sheets, it was an accounting peculiarity that allowed Japanese companies to value assets for the price they were purchased for, not the fair market value. Simply put, they may have paid $400 million for an office complex two years ago that would fetch just $200 million today, but the bank needn't take that embarrassing $200 million hit, as it could and did still count the purchase price as the "value" of the property. A strange practice to be sure, but millions of investors do the same thing every day of every year, unwittingly letting profits slip through their fingers.
As a professional trader for the past 22 years and as a mentor to many young traders and individual investors, I can tell you that the malady I'm about to describe isn't something which only individual investors struggle. It's something that everyone from the novice to the seasoned veteran has to deal with ? forcing yourself to forget what price you paid for your trade.
Whether I'm sitting in on a morning meeting with floor traders, or speaking to a crowd at an investment conference, invariably someone will say, "The CBOT mini-sized Dow was down 100 to 7900 yesterday, but that's OK, because I bought it for 7610 three days ago, so I'm still up."
They usually say this with a sense of pride, rather than embarrassment, perhaps thinking I will congratulate them on their shrewd purchase. Unfortunately for them, I don't applaud this behavior - I abhor it. It points out several weaknesses in their trading, not the least of which is their lack of understanding that every trade (investment) has an entry and an exit. Until you've actually closed the trade, you haven't booked the profit. If you make a timely purchase or sale of a security or futures contract, congratulations. In reality, you're only halfway home. You also need to capture that profit by closing out the trade. It doesn't matter whether you're bullish and your entry is a purchase, or whether you are bearish and your entry is a sale. You can't pop the champagne until you've cashed in your chips.
FORGET WHERE YOU GOT IN, IT'S WHERE YOU CASH OUT THAT COUNTS.
The other problem with this behavior is that the investor or trader remembers the entry price. That's a mistake because what you paid, or where you sold is of little consequence. What matters is where that stock, or commodity is right now. An opportune sale is wonderful, but where you cover that short position is eminently more important than where you established the position. When I'm looking at a portfolio, the last thing I care about is at which price the client established a given position. I care about the here and now, where I can buy or sell that asset this minute.
For example, the CBOT mini-sized Dow Futures may have been an extraordinary buy at 7600, but at 8000 would I think it still represents a value versus other investment opportunities? If my answer is that I wouldn't buy the CBOT mini-sized Dow at this level, then, frankly, why should I hold onto it? Isn't the answer that I should take my profit and wait until another long or short opportunity presents itself? Of course, that is the correct answer, but you'd be surprised to see how many people believe that they are "playing with the house's money," and these are the folks who either take smaller profits than they deserved or, worse yet, turn their winning trades into losers because they remembered where they got in rather than remembering that nobody ever went broke taking a profit!
When I ponder why individual investors have so much trouble with this concept, I have to blame the tax code and the IRS, which doesn't recognize a profit or loss for individuals until they close the trade. This policy has bred the mindless tax-loss selling that shows up every December, as investors scramble to recognize losses and match them against their gains. Professional traders are marked to market every day, meaning the profits and losses are right there in black and red, so it doesn't matter whether we close our trades or not.
Perhaps another reason some of us seem so reluctant to forget our entry price is strictly ego. We want to tell someone else how clever we were. It's more fun at a cocktail party to tell your neighbor that you shorted Gold at $381 an ounce when it has retraced the move back to $370. Unfortunately they are missing the point completely that those $11 in profit are not yours to spend until you've closed out the trade. Pro's trade in and out so frequently it's nearly impossible to remember every entry or exit price. For example, my brother Pete, a former NFL linebacker for the Seahawks, Vikings and Buccaneers, is a specialist on OneChicago<sup><small>TM</small></sup> for Single Stock Futures (SSFs). Pete may make 100 to 500 trades per day in SSFs, hedging with 100,000 to 1,000,000 shares of the underlying stocks. If he happened to buy the low of the day, or sold the top he may remember it, but not in relation to the corresponding stock or futures trade. The past is just that, history. What matters is where he can get in or out this second, assuming reasonable risk to reap acceptable reward.
Here's a tip for how you can break yourself of the habit of remembering where you got into a trade: Sit with a friend and swap portfolios. Let him or her go over your positions and, conversely, you examine his or her portfolio. Invariably, you will find positions that seem to be ripe for harvesting. I think you'll hear conversations that go something like this:
"Gee Mark, I notice you're still holding onto the IBM 80 ? 85 bull-call spread. It's trading for $4.55, so I don't really think you can justify holding on for two more weeks just to make that last $.45. If anything, I'm more a seller of that spread at these levels."
"Well sure, Judy, but I bought that spread back in late November for just $2, so I'm?.OK, I get your point. But since your brought it up, what about your butterfly spread in Sears? What are you waiting for?"
Professional traders and money managers go over their positions every day, which is probably too frequent for most investors reading this column. Most of you already have full-time jobs and you pay substantially higher commissions than the professional trading community does. Daily portfolio assessment is not only impractical with your time constraints; it may also cause undo churning of commissions, which would erode your profits.
You need to strike a balance between forgetting the price you established your trade and completely letting the market trade you. You should remember that investments in the stock or futures markets are not the same as making a bank deposit and leaving the money there until you need it. A prudent investment with good risk / reward ratio can turn into a terrible position, with horribly skewed risk versus reward in a very short period of time. Prudent traders and investors should keep the odds in their favor throughout the life of their trade, keeping their eyes on the prize, but weighing the probabilities and getting out when they've exhausted the edge they originally sought to exploit.
When you conquer the problem of remembering your entry price and instead focus on whether you should be in that trade at this level, you will truly be on your way to managing your risk and trading like a pro. If you insist on "playing with the house's money," one thing is for sure -- it will be the house's money again! Remember the problems with those Japanese banks. It's not what you paid for it. It's where the market is right now that matters.
Want to know more? Submit a question to the author of this article (please include "NajarianStrategy" in question).
Interested in other trading strategies?
<hr> About Jon Najarian
Jon 'Doctor J' Najarian is a Chicago-based money manager and the founder of Mercury Trading, a proprietary trading firm. He hosts a daily financial radio program called "Taking Care of Business with Doctor J," on CBS Radio AM 670, and his market commentary and money tips are carried on Fox television in the Chicago market twice every business day. Mr. Najarian is chief market strategist at www.ptisecurities.com, a securities and futures firm he co-founded in 1991.
