You might have noticed that I use the phrase “know your max” loss frequently in my toots on Mastodon and posts on this blog. However, that’s a fairly loaded phrase that might need more explanation.

This post talks about boring stuff, such as calculating your max loss, and deeper thoughts around what hitting a max loss feels like.

The source

I originally heard about maximum loss on the Theta Gang podcast. Joonie drives the point home repeatedly that you need to do two things:

1. Know how much money you could lose if the position goes to maximum loss
2. Know what that situation would feel when you hit it (not if, but when)

These are two distinct items that require different levels of thought. Let’s start with the easy one.

Boring calculator time

Calculating your maximum loss is fairly straightforward for stock trades.

If you buy one share of Company XYZ for $100, then your maximum loss is $100. This requires that that the company completely loses all value (bankruptcy, fraud, etc) and you hold that share until it reaches zero. Most stocks really don’t hit absolute zero, but they usually have an asymptotic curve that gets really close zero really quickly without touching it.

Going from $100 to $0 (or something close to $0) hurts, but your losses are limited to just that $100.

Let’s say you bought 100 shares of that same Company XYZ for $100. That’s $10,000 of capital. If the company runs to zero, your loss is suddenly $10,000. This is not fun.

Some of you might be saying: “Well, it’s worse if you bought the shares on margin!” You are totally correct.

Many stock brokerages offer something called margin, which allows you to buy shares of companies using loaned money from the brokerage. You might spend $10,000 on shares, but your broker may show that it only took $5,000 of your capital to do that. The other $5,000 is margin.

Most investors will use margin carefully, but if you decided to buy 200 shares ($20K total, $10K on margin), that same loss situation turns ugly. When the $20K runs to $0, you lose your original $10K capital plus the brokerage will come after you for an additional $10K (for their margin loan).

🚨 Always, always use care with margin trading accounts. It’s extremely easy to get carried away with the extra funds and think “Oh, surely it will turn around!”

There’s a well known phrase from economist John Maynard Keynes that I remind myself of constantly:

Markets can remain irrational longer than you can remain solvent.

Truly knowing

There’s a difference between:

1. I used my calculator and I know how much money I’m risking with this trade.
2. I’m mentally and financially prepared for the worst to happen.

That second part hit me directly in the face several times before I really understood it.

In my early days of selling options, I thought the object of the game was to find tickers with huge amounts of implied volatility (IV) and sell options on those because there was so much money to be made. After all, most options expire worthless and selling options is a free money spinner, right?

Take a look through some of my old trades from 2020 and you’ll see a sea of red. Some of the losses were massive.

I knew my max loss on paper but I was not mentally prepared for it to occur.

Here’s a classic:

I said I was okay with potentially owning $FUBO at $50. I was wrong. There were many trades like these before I finally realized: “Wow, I’m not okay with this. This is terrible.”

Better habits

I changed lots of trading habits to gradually make improvements and that’s been paying off recently. Here are a few things you may want to consider:

Track and follow fewer tickers

One of my biggest mistakes involved tracking hot tickers and trying to guess where they’re going. I rarely learned enough about their market segment or whether the company actually made money.

These days, I track very few tickers and all of them are companies I’d like to own anyway. They’re also companies that I buy things from and recommend to others. I keep tabs on their quarterly earnings and track the personality of their price movements. I do my best to get to know the stock.

This allows me to dig deeper into the price movements and options trades. I can also see through some of the “news” published by the company and the analysts that follow it.

One of my favorite authors, Fred McAllen, has a good reminder in his books (paraphrasing here):

There are only two things in the stock market that won’t lie to you: price and volume. Luckily, they both appear on every stock chart.

Just a reminder: analysts and reporters were in love with Enron even as it went over the financial cliff into ruin. 😉

Wait, don’t chase

When you study a chart or review options data for a particular stock, set the points where you think an entry would be a good idea. Look for good spots to buy when price gets back to reasonable levels after a correction. Also look for areas where the stock price is outrunning its liquidity and those might be good spots to sell.

By setting these entry points, you’re less likely to chase a stock up or down and stick with better entry prices. This protects your capital, prevents overtrading, and reduces stress.

This is extremely difficult. When a stock has gone through the roof and the fear of missing out (FOMO) hits you hard, sticking with your planned entry points can be agonizing. Remember that stock corrections happen (in both directions).

Build the plan, follow the plan, and use what you learned to build the next plan.

No trades can be good trades

Sometimes stock prices go nuts. Bubbles happen. Just don’t be on a bubble when it pops. 🫧

It’s not unusual for me to look at a stock and say “That thing is way too expensive. I’m going to make a bearish trade because everyone else is crazy.”

In these situations, it’s completely okay to think that a stock price has gone way outside reasonable levels (up or down). Most investors who do their research will find their stocks reaching these situations. However, sometimes the best option is to not trade at all. (This was another gem from the Theta Gang podcast that took me a long time to understand.)

Instead of following the urge to trade against the crazy market, you can protest the price movement by simply sitting on your hands. You won’t put more capital at risk, you’re removing a tiny amount of liquidity from the stock, and you can watch the crazy price action from the sidelines.

This is also a good time to stress test your thesis on the stock. In other words: is everyone else really crazy, or did you miss something?

• Did something happen in the market segment that changed the valuation of a particular company?
• Is money flowing into (or out of) your stock because of something at a macroeconomic level?
• Did your company move into a new market segment and become more valuable?
• Is there a binary event (earnings, investor conference, produce announcement) happening soon?
• Is there a thesis on the stock that you could make that is the opposite of your current one?

I’m typically trading with a bullish bias, so I often ask myself what thesis I could make for shorting a particular stock. I dig into charts, options data, and earnings reports to see if I can poke holes in a bullish thesis.

Conclusion

Knowing your max loss means more than just calculating it. You must be mentally prepared for it before making the trade.

Adopting better habits helps you make better trades and be more comfortable with the potential of a maximum loss event. Track fewer tickers more deeply, set up the right entry points for trades, and know when not trading is the best available trade. 😉

Good luck!