Despite there being so many examples of share prices collapsing to almost nothing, I am still surprised at the amount of times I hear crazy things from the mouths of others. We’ve all been naïve at points and I certainly didn’t grow up teething on ticker tape, but one question I was asked this week was: “How can I lose trading CFDs if I just don’t sell and wait for it to go back up again?”
I tried to explain that you can lose on any stock and not just CFDs regardless of whether you sell or not. If the market is showing you a loss, then it is – plain and simple – a loss that you have not crystallised yet. And just because the loss isn’t realised, does not mean any less that it is not a real loss. If it affects your net worth, then it’s real. If you’ve just given back £10,000 needlessly because it was ‘house money’, then you’ve just waved goodbye to an all-inclusive five-star holiday (although one suspects those may be going cheap now).
The ‘house money’ fallacy continues to trip up traders across all markets. The litmus test is this: if you closed the position and banked the gain by mistake, would you be so willing to immediately open the trade up again? Of course not, because the risk/reward would have moved significantly against you. Many traders believe that risk is constant. It isn’t. If we’ve set stops and set targets, then the further the price moves towards the target and away from the stop then the risk is moving against us (although we are profiting from this move). Think about it: the best entry is the one where the odds are in our favour. For example, a breakout trade as it breaks out of resistance – and not chasing it a few points higher. By thinking about your trades in this way, hopefully you will avoid the house money fallacy which sees millions of pounds of traders’ cash go up in smoke every year.