Thursday, March 28, 2013

Traders and shopkeepers

I occasionally come across individuals who are suffering large losses in a position or two in their portfolio. Quite often these are investors, who seem to ignore the fact that a paper loss is a very real loss. When it is crystalised is neither here nor there. The fact remains that they end up carrying a loss that is material to their equity, which is never a good thing.

As I've alluded to in several posts, these very large losses will have started out as small losses, however there are people out there who think that when price goes against them, the potential to make a profit on that stock or instrument has improved! Quite often, they add to a losing position. At this point, I remember the large notice in Paul Tudor Jones' office: "Losers average losers".

This approach is the opposite to that of a trend follower. When price starts going against them, it may be the start of a reversal in the direction of price. As a result, trend followers only ever enter new long positions on new highs (strength), or short positions on new lows (weakness).

Compare a trend follower to a shopkeeper. A trend follower protects his equity similar to a shopkeeper maintaining his line of stock. Without any equity, a trader cannot trade, in the same way that a shopkeeper can only trade if he has stock to sell.

If a shopkeeper has a poorly performing stock item, he discontinues selling it, and replaces it with something else that he feels would sell better. Similarly, if  a trend follower has a poorly performing trade, he will cut his losses and close the position (as price is not acting as intended) and seek to replace it with another position.

On the other hand, if a shopkeeper has a hot item that is flying off the shelves, would he decide to stop selling it? Of course not, that would be silly. A bit like a trader closing a profitable position as it was 'overbought'...

Now consider the investor or trader who has let a poorly performing position get out of hand, resulting in big paper losses. That would be like a shopkeeper having a store crammed full of items he can't sell for love nor money...The end result is that both could soon be out of business.

Alternatively, would a shopkeeper decide to stock up his store with poorly selling items, which he has little chance of selling on and making a profit? That's a bit like going long on a stock that's in a clear downtrend.

Remember that as traders you want to place the odds in your favour. You may get lucky and pick the absolute 'bottom' in a poorly performing stock which makes you a lot of money, but would it be better to wait until the odds have turned in your favour, that the stock had bottomed out, and was now showing signs of strength? Consider those who bought Apple on a pullback at £650 after it topped out at $700 last autumn. Or at $600, or possibly at $550. Maybe at $500? Or, going back in time, all those investors and traders who enthusiastically bought into Enron after it topped out somewhere around $100, all the way down to 50c. You get the picture...

Finally, a shopkeeper would never sell just one item, in the same way that a trader would never put all his capital into a single position. Each spreads their risk around by diversifying and holding a selection of items that all have the potential to generate profits, as some will perform better than others.

So, try thinking of your trading as being akin to running a shop.


  1. Another excellent post, TraderSteve. It is interesting how a shopkeeper, by keeping his shelves stocked with high demand items and removing low demand items, is not only able to maximize his profits but also able to benefit society as whole by doing so.

    Trend followers, often broadly referred to as speculators, are often looked downed upon as greedy (or worse).

    Question: Do you think that trend following traders, by allocating scarce capital into high demand areas, benefit society?

  2. Thanks Danny. I've never got the trend followers are greedy argument - remember, we don't create trends, we only hop along for the ride!

    Never thought about your question. Without getting into a political or ethical debate, I guess the answer is yes, but some people would argue that by going short (and staying short) in 2008, trend followers could have made things worse.

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