Thursday, February 12, 2009

Getting Whipsawed!

Whipsaw is a wonderful description of a trade. Specifically you buy some stock, it goes down 20% and you sold out, intending to preserve whatever capital you have left. And the next thing you know, the stock goes up 100%! Shiok right!

Actually the fear of getting whipsawed is so great that it causes a lot of investors to make silly mistakes. But if you think about it, even if you really get whipsawed, it's not a big deal except for the psychological factor. Say you cut loss at 10% and the stock subsequently rallied, so you would have lost just 10%. But if you did not cut loss and stock continues to decline, you will eventually lose maybe 50-60%.

Let's for argument sake, make the example a bit more mathematical. Say you bought a stock at $10 and it plunges to $8. There is a 50% chance that it may rebound 50% to $12 and 50% chance that it plunges another 50% to $4.

So you have two choices now:

Choice 1: If you cut loss, you lose $2

Choice 2: You wait out the storm,
If you get lucky, you make $2, as the stock rise back to $12
If you are damn suay and the stock continue to plunge to $4, you lose $6

Let's assume it's 50:50 between the $2 and -$6, your expected return of not cutting loss is $-2 (0.5*2+0.5*-6), which doesn't make you better off than if you had cut loss. Actually it's probably 70-80% chance that it will go down. Logically thinking stock at $10 which had gone down to $8 should continue to decline bcos something had gone wrong in the first place. So unless a new positive catalyst appears, the stock will not rally.

However the fear of getting whipsawed is so great that it blurs the rational mind. If the stock did rebound and go back to $12, most pple would rather kill themselves than to admit that they only lost $2. This fear of getting whipsawed makes us hold on to our losses longer than we should.
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