Staring down dragons…..

I like to use the Deep Pocket Options blog to teach a little bit about how traders think. The market has been down in a somewhat disorderly way since the third week in January. There has definitely been some panic selling in certain symbols and sectors. Retail is down big (we trade the XRT), Boeing has been sold off savagely, just to give a couple of quick examples.

Downturns like this one, where there is no clear reason for the fear but many cloudy speculations about the future, are usually great opportunities. There is an old Chinese proverb that goes something like this: “When you see 10 dragons coming down the road, 9 of them will never get to you.” It seems to be true that 90% of what we worry about never happens, and for the 10% that does? — we had a 90% chance of not seeing that one coming along anyway!

As traders, when the market appears to be coming apart, it is easy to fall into the dragon trap and start to fear all 10 dragons. Don’t do this…you will convince yourself to do the exact wrong thing at the wrong time and panic out of positions. Experienced traders know how to game these conditions. You buy a little as the market drops, always leaving yourself enough cash to buy more if it gets cheaper.

One thing you must never, ever do is to increase you purchases on a symbol as it falls. Do not think you can buy 100 shares if it’s down $1, then maybe 200 shares if it’s down $2, and so on. In the world of gambling this is known as the Martingale system. Sure, it might work, but the odds are stacked hugely against you. Most likely, you will be destroyed by this thinking. It is much more gambling than trading – and completely ignores all need for risk management.

I’ll use Boeing as an example. I own Boeing, and my position is down as Boeing has fallen from 144.57 on January 22 all the way to a low of 118.77 earlier today. That’s a big drop in a short time period, and I have watched my position fall in value. Along the way I have sold some calls to make a little money, but the drop has been so consistent every day, that I have held back on my call sales. I don’t like to be selling calls on down days. That’s a great way to be whip-sawed out of a position.  I have sold a very small number of puts during the drop so I can very slowly increase my position. I don’t see any fundamental reason for Boeing to be dropping like a stone, so experience tells me that this is mostly fear driven and that it will pass. The problem is that I don’t know when it will pass. Maybe today, maybe next week or next month. That’s the problem with increasing a position at an exponential rate on the way down – you may run out of money before the symbol hits bottom.

Stay calm, buy a little more as it drops and wait until you believe it has turned the corner. That is the time to increase your purchases, when risk has dropped, not as it is increasing.

Be aware of the dragon, but don’t fear it. Stay invested, my friend.

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