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Bulkowski's Sacrificial Trading

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Written by and copyright © 2005-2019 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners.

This article discusses trading psychology, that of making a sacrificial trade to increase trading success. It is based on John Chapman's article in the October 2012 issue of Technical Analysis of Stocks & Commodities magazine.

The Sacrificial Trade: Problem One

Are you like Basketcase Bob? He buys 1,000 shares of Podunk Computer for $10 each as a day trade. Visions of riches fill his brain as he waits for confirmation. His girl friend has been bugging him about taking a vacation to some exotic locale, and after a few more trades, he'll have enough money saved up to afford it.

As soon as the trade confirms, the stock drops. It's not a skydiver plunge, rather price eases lower bar by bar until he is down 10%. "There's a support zone 5% lower," he mumbles, so he decides to hold on until the reversal.

The stock blows through support at 8.50 (15% below his buy price) without stopping and closes the day at 8.25. His day trade has turned into a swing trade when he holds it overnight.

The next day, the stock gaps open lower on an announcement of anticipated weak earnings. The stock opens at 7.50. Within minutes, it's at 7.00 when he decides to sell.

Basketcase Bob lost 30% on this one trade. He pounds his fist on the table and rips down the poster of sand covered beaches beside an ocean reflecting a rainbow sunset.


The Sacrificial Trade: Problem Two

The next day, Bob checks the news on Podunk Computer before the open and sees that a broker has recommended the stock, saying that investors should consider this a buying opportunity to get in cheap on the stock since the weakness is only expected to last a few months.

He decides to wait 15 minutes after the open before buying. By the time he snags shares, the stock is up 15% and climbing. He's late getting into the trade but that doesn't seem to matter because price is climbing.

The stock becomes a moon shot and rises another 5% before going horizontal.

Basketcase Bob is wringing his hands. He wants to hold on for additional profit, but expects a swift plunge once is breaks through support. When a red price bar appears, he decides it's time to jump ship and sells his entire stake.

The red bar was a fake out. The stock resumes its upward move and by day's end, the stock is up 25%. Bob's fingers curl into fists. He looks around for something to punch, kick, or throw. Instead, he pounds his fists against his head, trying to knock some sense into it.


The Sacrificial Trade: The Solution

"Much of trading involves a battle to maintain discipline under stressful conditions," writes Chapman. When a trade goes bad, the pressure increases and emotions cloud your trading ability. You have difficulty making rational decisions. What's the solution?

Sell a portion of the position.

This does three things.

  1. It eases psychological pressure.
  2. It cuts the position size, thereby reducing risk.
  3. If others sell too, it becomes a selling climax. Once the selling stops, the stock is free to recover.

"The change in your emotional state after making that sacrificial trade can be profound," he writes. He describes being depressed as a losing trade unfolds, but after making the sacrificial trade, his emotions flip, and he worries about the stock rebounding! "You could be angry with yourself and toy with the idea of buying back the tradable that you sold as a sacrifice."

That doesn't always happen, of course, but after completing the sacrificial trade, your emotions cool, allowing you to make a more rational decision about what to do with the rest of the position. You may decide to sell it, too, and that's fine. You may decide to hold on to see if others have thrown in the towel. Once their selling pressure abates, buying demand should push the stock back up, allowing you to narrow the loss or turn a losing position into a profitable one.

The Sacrificial Trade: How Much to Sell?

Chapman does not give specific guidance as to the amount to sell. In his example of five lots of sugar, "I would sell one lot -- the sacrificial lamb," he writes.

If trading 1,000 share blocks of stock, then maybe 100 shares would work.

It may be that the act of selling is what's important, not the size (except for risk reduction, mentioned above). What you are trying to do is fool your brain and reduce the emotional pressure.

What this technique is not trying to do is scale out of a position by selling a portion of your holdings until you have sold them all.

-- Thomas Bulkowski


See Also

Written by and copyright © 2005-2019 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners. Nothing is better than eternal happiness. A peanut butter sandwich is better than nothing. Therefore, a peanut butter sandwich is better than eternal happiness.