Retail stock investors: think before you leap

[Joy]

Retail investors are still the backbone of the Indian stock market.
There are millions of them spread across the country, trading through
thousands of terminals irrespective of a volatile market. One thing
that perennially keeps repeating with these players is that they tend
to lose more money than what they make. There are many reasons for
this. One or more of these apply to each trader at different times.
One has to understand the ways of making trading profits. In a
nutshell, there is only one way. Sell high and buy low if you are a
short seller.

Take case of Pareshbhai, a trader. This is exactly what he is trying
to do. He is, however, not putting in adequate thought before entering
the trade. He is clueless as to why he should buy at this price and
the risks that are inherent to the trade.

He has heard that a particular stock will go up. And that’s enough for
him to go and buy that stock and take a position. He has already
formed an opinion that this stock will go up. And this is certainly
not a healthy sign while investing in the stock market.

Pareshbhai, like most others, is generally a long player (buys first
to sell at a higher price later). He is very rarely a short player.
But the markets move in both directions. His desire for going long
comes as a disadvantage at the start itself. There is only a 50%
probability that he will end up making a profit. Besides, his timing
of entry is often questionable. His entry is at a time when the stock
has already moved up considerably. Therefore, he is starting with an
unfavourable risk reward ratio. The other big negative factor for
Pareshbhai is that he is overtrading. He is taking an exposure far in
excess of his capacity. Capacity would have many connotations, not
just financial. It is beyond his ability to pay for the loss. It is
his willingness to accept the loss, because if he accepts it, he will
realise that he took a wrong decision. That’s something he can never
do. Considering the financial implications, exposure generally amounts
to overexposure because Pareshbhai never asks the question “what
if...?.” What if my call goes wrong? What if the stock I buy falls? If
it falls, where do I take the loss? Or should I wait and watch before
entering?

Since he has not asked these questions, he obviously has no answers.
Therefore, he has taken a position without condsidering the risks.
Although he has seen various sides of the market, he prefers to ignore
reality.

A trader’s positions are generally leveraged. In the futures market,
he only pays a margin to the exchange through the broker. And in the
cash market (where purchases and sales result in deliveries), it is
usually funded by the broker or bank or a third party. The trader only
pays a margin.

Once Pareshbhai is standing on profit, he is already on the lookout
for how to make more money.

When he pays a margin of 20% of his exposure, he would increase it by
50% if the stock goes up by 10% and if he has a good run, then the
exposure keeps increasing without him having to invest further in the
margin. Even if he has booked a profit in one stock, the position will
be replaced by another. And so on. Typically, the average profit
profit is 2% to 10%. For instance, 5% profit looks attractive on
leveraged positions. On a Rs 10 lakh position, it amounts to Rs
50,000. Too good to miss. But this profit is reinvested as margin.

And further exposure is taken. At some point, if his stocks fall, he
stands on his entire position at a loss. He does not book the loss as
he has taken the position. The exposure has multiplied now. A 5% loss
on a 20 lakh exposure amounts to a loss of Rs 1 lakh. That’s too much.
That’s 50% of the profit that Pareshbhai made. Now he feels this stock
will bottom out and his fellow traders feel the same way. But
tomorrow’s another day.

Now he’s extremely attached to his position. He just can’t let go, as
the loss is too much. And he wants to use this money to make more
money. If he books this loss, what happens to his dreams? Finally, the
stock takes a further sharp dip. And the speed of this fall is much
higher than that of any of the rallies. The loss has gone up to Rs 3
lakh. Pareshbhai wants to exit before making further payments. And he
finally presses the panic button and exits. The average loss would be
10% to 20% or even higher.

Now what does that mean? Is the numbers game favouring Pareshbhai?

First of all he is usually a long player in a market which moves on
both the sides. He is starting with a disadvantage. He has no
conviction for taking a position and about the timing. Invariably, he
will enter after the stock has already gone up. He has no system of
risk management. He is holding the position with a strong view that he
will only make money.

This puts him at a psychological disadvantage. Further, he is
overtrading and keeps expanding his position as his profits
accumulate. With no risk management in place, he is creating a
mechanism of taking small profits on small positions and big losses on
big positions. As described earlier, if his average profit size is 5%
and average loss is 15%, in the medium to long term, there can be only
one result.

The solutions are easier said than done. It involves inputs that are
not necessarily financial in nature. It’s more of discipline and
making some rules and following them. First of all, there should be a
conviction before taking positions. This exercise itself will
eliminate doubtful calls. Then comes the issue of overtrading. The
exposure must be commensurate with the ability and willingness to take
losses, in case there is one. This thought process will help the
trader remain detached from his position. A diversification with a mix
of longs and shorts would create a natural system of risk management.
And finally, a habit of sitting on profits longer than on losses would
correct the numbers game.

(The author is CEO, Lotus Investments & Securities)

Source: Financial Express