“The stock is down 25%. But I didn’t lose money because I didn’t sell it yet.” That’s a quip from a conversation I had with a friend in a London pub a while back (her talking, not me). From there the conversation ultimately finished with an, “I agree to disagree” ending. I told her she should ask her broker for that money she “didn’t lose” and see what happens. I still didn’t get through. But, you know, I can’t blame her for thinking this way—most humans are actually hardwired to think that way. It’s a thing. And that thing is called “The Sunk Cost Fallacy”. What Are Sunk Costs? The concept of Sunk Costs relates to when you’ve already spent time, money or effort on something that is not working; but you don’t want to give up on it because you’ve spent that time, money or effort already. Never mind that maybe you can’t get it back (or are unlikely to get it back). You don’t want to “lose” what you spent, so you stick around—sometimes way too long. You’ve probably experienced this in your life outside of trading. Maybe you bought tickets for a game and it turned out to be a blizzard, so you go anyway so that money isn’t “wasted”. How about installing new air conditioning on that 10-year-old car? Maybe you stayed in a relationship that just wasn’t working anymore, but was… comfortable. It works the same with trading and investing. And it’s hard to shake that thought pattern. And the tax code doesn’t help either. It sort of re-enforces that “logic”, as you don’t get the tax write off unless and until you lock in the loss. So, it doesn’t feel like a real loss. And, hey, it might come back, right? Behavioral Economics and Trade Management The real problem here is that this fallacy in logic can lead to poor trade management, usually in the form of holding on to your losing trades too long. As they say, the first step in recovery is recognizing you have a problem. Just knowing that people are wired to think wrongly about certain things is an important step. It’s how your brain works and it’s not logical. So, what do we do in these situations when we have a loser and don’t want to lock in the loss? I have a couple thoughts… Have a Trading Plan Deciding how to manage a trade when you’re angry is a terrible idea. There’s nothing guaranteed in trading. But if you’re making decisions based on emotions, you’re pretty much guaranteed to lose. Start with a plan. If I buy this call now, where will I sell it for a profit if it works out? And where will I take my loss if it doesn’t? I like to use GTC (Good Till Cancelled) OCO (One Cancels Other) orders to make trade management easy and mechanical. Then it’s set it and forget it. …Oh, and if you get stopped out and lock in that loser, remove it from your watchlist and never look back (otherwise it’ll drive you crazy). Pick Winning Trades You have finite capital in your account with which to make your trades. Question: Would you rather have on “good trades” or “bad trades”? (Duh.) When we hold on to losers out of hope, stubbornness or good old-fashioned revenge, you can’t use that capital for anything else: You stay in the losing trade instead of getting into one that might have a better chance of winning. Remember: Just because you lose money in XYZ options, doesn’t mean that’s where you have to make it back. Play the odds. Have your money in trades most likely to win. Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by emailing investorservices@theocc.com; or from The Options Clearing Corporation, 125 S. Franklin St., Suite 1200, Chicago, IL 60606. The content posted by our authors is intended to be general education and / or general information in nature. We are NOT providing advice for any individual trader. No statement made by our authors or subscribers is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions. Futures and forex trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing one's financial security or lifestyle. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results.You’re currently a free subscriber to Wealth Building with Options. For the full experience, upgrade your subscription.
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