Most traders at some time or another will have done ‘The Revenge Trade’. It’s one of the classic mistakes of trading. The Revenge Trade leads to immense frustration, deep anger, and a lot of soul-searching. More crucially, it is a major contributor to under-performance and to failure as a trader. – As with the image above, it is the metaphorical equivalent of punching yourself in the face, over and over again.
How might the Revenge trade look?
Let’s consider a simple example: You walk into the trading room, you do your early morning scan of the markets. – In your mind you start to formulate some trade ideas for the day. – Lets assume you are trading the SP500 futures.
You follow the opening price action and you quickly form a short-term bullish view. The market is trading around the 2130 and you think it is worth a buy. You like the price action, the momentum behind it, and the fact that its recently cleared and held a good resistance level. You have a sense that most short-term traders are not yet on the long-trade, giving it potential for further upside if they come on board. Your hunch is that in the next few days you could see a move up to 2150.
Also emboldening your view is that your ‘Stop’ on this trade would not be far away, making it a great risk/reward trade. You believe it has a good possibility of holding above the 2127/28 area, and if it breaks there then you would have a stop at 2125. – So you are sitting there with a potential 4 to 1 payoff, a very favourable set-up.
Day 1: You enter the market paying 2130 for 10 futures. That’s $2,500 a point. If you are wrong your risk is $12,500, if you are right you are looking at potentially a $50,000 profit, maybe more if you stay long beyond there. The market goes your way almost immediately, jumping to 2135. It then stalls and starts slowly ticking back down, it briefly tests the support but manages to hold above 2128. Later that day it starts rallying again pushing up to 2137, before closing at 2135. You are off to a good start.
Day 2: The next day it opens with further gains, pushing up to 2140. The trade is going well, but then some news hits the wires which sends the market lower, and an intraday sell-off starts to gather steam. Now you aren’t quite feeling so confident, people around you are selling and talking about a move far lower, the market drops sharply and soon it is testing 2128. Now you are starting to get nervous, instead of looking at the potential profit, you are on the defensive and fearing your stop at 2125 will be hit. The index ticks down to 2127, before stopping its decline and clawing its way back up slowly to just over 2130. Many day-traders around you are now short.
In your mind the doubts start. As you watch the price action you start to question whether your view is right! You start wondering whether you would be best salvaging something from this trade whilst you can. Thus you make the decision to sell out at 2130. Now you are out flat, no loss or no gain. The market again turns down to 2127, and for a short time you feel mightily relieved, giving yourself a metaphorical pat on the back.
For most of the rest of the afternoon the index remains in a tight 2127-2130 range. Then in the last half hour it starts climbing, 2131, 2132, 2133, 2134, the intraday shorts have run out of patience and are now buying back. The market then puts in a surprisingly strong close, moving up sharply in the last few minutes to close at 2140, a gain of 6 points on the day.
You are left feeling angry and foolish, the market has sucked you out of what was a good idea. Your original boundaries for your trade idea were respected, but you had let the noise and the uncertainty get the better of you.
The Regret and the Pain.
You ponder the day’s events overnight. Outwardly you appear fine and calm, but inwardly things are turning over in your head. There is a circle you need to square; a cognitive dissonance is taking place in your mind. On the one hand you think, ‘I’m a good trader who knows what I am doing’, on the other hand your thinking ‘I’m an idiot, I’ve been made to look and feel stupid’.
The Next Day.
You go back in to work angry with yourself, angry with the situation, angry with the market. You are determined to right the wrong inflicted upon you.
Day 3: The market immediately opens lower and drops back to 2135. Immediately you feel a little better, perhaps you were right to sell after all, perhaps you weren’t such an idiot!! – Yes, your timing wasn’t great, but your new view was possibly right after all. For a short time this helps you square that circle’; ‘I am a good trader and not a fool’. – (Here comes the Ego: You have now justified your actions ‘in your mind’. – The need ‘to be right/to be proved right’ (validation of your brilliance) has been achieved.)
Now you are going to show ‘The World’ and ‘The Market’ just how good you are. (Here comes the ‘Revenge Trade’; You are now personalizing ‘the World’ and ‘the Market’, as if they somehow care about you.).
You sell 5 lots at 2135.
In your mind your are right and this is going lower, a lot lower. (No one messes with you and gets away with it: In your mind you believe ‘the market bends to your will’). You have convinced yourself of this, and now you are ready to take advantage of this. But the market has other ideas, it plays around a bit in the range in the mid-2130s, so you what do you do. You sell another 5 lots. (If you are right in 5, why not be right in 10 instead, maybe you can even help give it a slight nudge !!!!). You are now short 10 lots at 2135. But the market starts to rally, soon it is back to 2140. But so convinced are you in your ‘rightness’, that any objectivity, a characteristic you usually possess in spades, is no longer part of how you are working at this time. You convince yourself that this rally is just a blip, a re-test of last night’s close. Emboldened by your self-justifying rationalisation, you are staying with this, even considering adding some more. And duly you sell another 5 lots at 2140. You are now short 15 lots in total.
But the market doesn’t play to your tune, it keeps on rising.
Now you are starting to get fidgety. An uneasy feeling starts to descend over you. You have no plan, no strategy, no prearranged stop, no levels, and if you pull the plug on the trade, you are an even bigger fool than yesterday. You are now relying on that most fickle of all allies, ‘hope’; but hope is not a strategy. The market continues to climb:. 2145, 2146, 2147, you are glued to the screen, you cannot see or hear anyone else, all sense of perspective is gone, you have become increasingly animated and visibly angry. – A sign to all colleagues who may be long, that this move still has legs, until at least you cut out. – You however are fully invested in ‘the pain trade’.
Then the market hits 2150. – Enough is enough, you pull the plug, you square up. Where you should have been booking a $50,000 profit, you are now booking a $50,000 loss. A total cost to you of $100,000.
That is the Revenge Trade.
But it is unlikely to end there: The new sense of self-doubt, the hit to your confidence, the damage to that most vital of assets ‘self-belief’, may potentially be more damaging in the long-term than the actual physical hit. Dennis Gartman’s 3rd Golden rule of trading states that:
‘Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.’
There is a Chinese proverb, which it would do well to heed: ‘He who seeks revenge should remember to dig two graves’. However in trading, this could be adapted, because in trading you only need dig one grave.
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