This Accounting Term Can Help You Avoid Big Trading Mistakes

Last week I wrote about setting and honoring stops and how the hardest part is actually doing it. A common theme in almost everything I write about trading is discipline, and the hard truth is that every trader loses it at some point. You skip a stop because you are sure the stock will bounce, or you simply overlook it. Small losses start to pile up. Or the market rolls over hard, and positions that looked fine a week ago are suddenly deep in the red.

It is agonizing, but it is inevitable. Even the best and most profitable traders go through periods when it feels like they can’t do anything right. Many traders wallow in misery, but what separates the great traders who survive and prosper is their next move.

The Deer in the Headlights

The default reaction when the Market Beast is kicking your ass is to freeze. The bigger the losses grow, the more likely you are to tell yourself it is too late to act. So you just sit there, watch the situation get worse and hope it gets better.

It is an understandable reaction. You feel that when you finally do act, you will do it at the worst possible time. You will sell the low, and the stock will turn right around and go straight back up. So rather than taking control, you do nothing and hope for the best.

The problem is that doing nothing is still a decision. It is just one you make by inaction. There are plenty of times when doing nothing is the right choice, but it has to be a conscious choice, not the result of being frozen. Inertia hurts traders more than almost anything else, and it does the most damage when you can least afford it.

Forget What You Paid

The way out of this misery is a simple mental adjustment called mark-to-market. Mark-to-market is an accounting term that means valuing an asset at its most recent market price rather than at what you paid for it. It is used for a variety of reasons in accounting, but it can also be a powerful psychological tool for traders.

The price you paid for a stock is a sunk cost. The money is gone, so, aside from taxes, the loss amount is irrelevant now. You can’t go back and change your entry price, so dwelling on it is pointless. The big unrealized loss you are staring at is history. What you can control is what you do from here.

So let’s pretend you bought that stock today. Today’s price becomes your new cost basis. You have no profit and no loss. It is a fresh start with a clean slate.

Making a New Plan

Once you take that step, you can make a plan without the heavy weight of emotional baggage. Look at the stock with fresh eyes. You probably already know a lot about it, but look at it closely and evaluate it objectively. Then ask the obvious question: Would I buy this stock today at this price?

If the answer is no, you shouldn’t own it. It isn’t a position anymore. It is a bad habit. Sell it and move on. Often, you will feel great relief just to have the cursed thing off your screen, so you no longer have to look at it or think about the mistakes you made.

If the answer is yes and you would buy it here, treat it like a new buy and do everything you would for a new buy. Where is the stop? As I wrote last week, set the damn stop and size the position to it. If the right stop is far away, you may need to own less. At what point will you take some gains? Under what conditions would you buy more? Write it down the same way you would for any new trade.

You will be surprised by how different the answers are. A stock you have been holding at a significant loss usually looks terrible on the chart, and you are only holding it because you are emotionally and financially committed. When you look at it as if you just bought it, that commitment disappears, and the decision often becomes obvious.

Break the Inertia

Sometimes the hardest part of trading is making the first move. If you are frozen, my best advice is to do something. Break the inertia. Stop looking for a reason not to sell, and just dump something. Perhaps it will be the wrong time, but it is surprising how much action shifts your mindset. You will feel like you are in control again. Even if your sales turn out to be badly timed, you will feel energized and optimistic about the new trades you can now make.

If the whole portfolio feels like a mess, there is nothing wrong with clearing the decks and going completely to cash. You are freed from the stocks that have been causing you stress and anxiety, and you won’t be driven to constantly second-guess why you are holding something. Cash is power. If the market turns higher, you can buy quickly. If it keeps falling, you are in position to take advantage of it. The market looks completely different when you are sitting on a pile of cash and looking for a new opportunity.

And if you sell something that later sets up again, you can always buy it back. As I wrote a couple of weeks ago, a sale doesn’t have to be a goodbye. You can remount the stock with a new plan and a new stop, and you will do it with a clear head instead of a pile of regret.

Why It Works

One reason support and resistance exist is that people remember their entry points and react emotionally as a stock moves above or below them. A stock that rallies back to where many people bought it often stalls, because those buyers are desperate to get out at breakeven. That is the market telling you how powerful cost basis is in people’s thinking. It also shows how irrational that thinking is. The stock doesn’t know or care what you paid for it.

Marking to market takes you out of that emotional group. Instead of waiting for a stock to return to your entry price, you make decisions based on what the stock is doing now and what it is likely to do next. That is the only thing that matters.

You can apply the same idea to your entire portfolio. Stop measuring yourself against where your account was before the poor period began. That number is just another cost basis, and chasing it leads to bigger bets and more desperate trades. Start from where you are today and focus on making sound decisions from here. You aren’t trying to make up for past mistakes. You are simply doing the right things as you move forward.

A Fresh Start Anytime You Want

One of the great things about trading is that you can start fresh anytime you want. If you take a hit, wipe the slate clean and start over tomorrow. You might have less capital to work with, but you can dump the losers and start without the baggage.

Good trading largely comes down to controlling our emotions. We want to act aggressively at the right time, but we can’t if past mistakes haunt us. The market looks totally different when you view it as your first day holding positions. If you are in a funk after a tough period, mark your stocks to market, make a new plan and get back to work.

At the time of publication, DePorre had no position in any security mentioned.