Wednesday, June 20, 2012

ADM: Failed trade post-mortem

One rule of a successful trading game is to never let a failed trade go by without figuring out what went wrong.

My sideways position opened Thursday on Archer Daniel Midland Co. (ADM) within hours of its  hit the stop/loss level I had set when I opened the position. It was a spectacular failure on timing, although a damp firecracker on loss -- the iron condor position only cost me $23 per options contract, not counting trading commissions -- peanuts in comparison with the value of the position.

You can read my analysis of ADM, posted yesterday and updated with the position outcome, here. And a more comprehensive discussion of stop/loss methods, here.

But my focus in this discussion in on a specific trade: ADM.

So what went wrong?

My entry was $30.53 on the stock price. My stop/loss was $30.28 on the stock. I chose that level as being just below downside resistance on a half-hour chart.

The stock took that level out when it dropped to $29.33. It has since reversed and closed today at $29.88.

Here's what I think went wrong:

Error #1: I set the stop/loss on a half-hour chart, whose granularity is way too fine to filter out the normal jitterbugging of the markets.

Had I been using a chart with daily bars, I would have seen resistance points at $30.14, $29.32 (the low set the day before a downside gap), and $28.11.

Conclusion: My stop/losses on stock-based trades should always be set on a daily chart. The immediate price action is important, but the larger context is as well.

Error #2: The magnitude of the stop/loss was too small, and recognizably so by several criteria.

The stop/loss was a mere 25 cents below the entry price. This is on a stock whose daily trading range has been 67 cents wide on an average of the past couple of weeks. (I'm using the Wilder average true range -- ATR -- indicator for the calculation.

One ATR would have set the stop at $29.86, and it still would have been hit. A common practice is to use double the ATR, which would have set the stop at $29.19, preserving the position.

Moreover, an iron condor is not a day trade. It is intended to hang around for at least a few weeks in order to earn its profit. The implied volatility on trading day showed confidence that 68.2% of trades would occur between $28.32 and $32.74 over the next month. On that scale, $28.32 would have been an appropriate stop/loss.

Using a weekly time scale for the implied volatility, the stop loss would have been set at $29.47, and the position would have been taken out.

So I set the stop as though it was a day trade, and that was an inappropriate level of analysis for that position.

Error #3: I bought into a downtrend.

When I opened the position, ADM was trading at resistance set last April. The daily bar on trade day was down -- an intra-day downtrend.

I focused my attention on the resistance level, and failed to take the very near-term trend into account. In doing so, I broke one my rules: Never buy into a downtrend.

I would have done better to wait for a confirming intra-day uptrend before opening the position.

Here's what I think went right:

The stop/loss worked. It got me out of a position that was falling to a lower low, piercing the floor of a sideways trend and setting up a multi-day downtrend. Whether getting out was the right thing to do will seen in later trading. The price the day after the trade set a new lower low, but then retreated, although it still closed below the prior day's low. So it's a downtrend.

In summary:

The stock didn't do what I expected it to do. My stop/loss got me out with a very small loss. As a trader, I judge potential positions based on what's before my eyes. My crystal ball is broken and the dog ate my tarot cards.

I trade in the Now, and absent knowledge of the future, how I interpret the Now can sometimes be wrong in light of later events. This is the nature of the world and its interaction with the human mind.

I once had a wise trading coach tell me, "You lost money? So what. Did you follow your trading plan? Then the trade was a success. Pat yourself on the back and move on to the next trade."

I made one error in executing my trading plan -- listed as #3, above. I followed my plan in many other ways. So in my coach's eyes, my ADM position wouldn't be a total failure, and I think he would rank it as a partial success.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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