Why the Death Spiral could get you Broke

If you don’t learn to stop the bleeding – i.e., stop losing money hand over fist in a rapid, downward, account-draining spiral – I can almost guarantee you that you will blow out your account. And it’s no fun staring at a zero balance, in shock, and wondering, “How did that happen?” It’s a classic trading mistake, one which unfortunately befalls nearly every trader at least once in their trading career (Oh yeah, I’ve done it). Some of us affectionately call it the Death Spiral.

 

How the Death Spiral could get you Broke?

The Death Spiral is when you just endlessly spin one bad trade after another, usually ever-convinced that the next trade will work out great and that you’ll make all money back, until you’ve completely blown out your account in just a matter of a few days, or maybe even just several hours. The leading causes of the Death Spiral are three-fold:

1) Refusing to accept a loss; Not cutting your losses short

2) Not being willing to admit you’re wrong

3) Not having (or following) a firm rule on daily drawdown

 

The Death Spiral usually begins with just one bad trade that you could easily survive and move on from. But, for some insane reason, you don’t move on from it – you get stuck on it, and your trading spins totally out of control, and out of the realm of logic and sanity, from there.

 

First Scene – Smoking Gun Appears

All right, just sit back and watch this, and thank God you’re not actually doing it at the moment. (And hopefully learn to never do it.)

…You’re looking for support in Gbp/Usd at 1.7050…there’s even a minor pivot point support at 1.7042…the low of the day is 1.70141, and price has just moved back above 1.7050. So, you put an order in, buy yourself some Gbp/Usd, with a stop at that 1.7041 low. Reasonable enough, worth a shot. You’re stopped out – 14 pip loss – not good, but not the end of the world either. Now, at this point, a smart trader would simply turn his sights elsewhere – or if he remained in Gbp/Usd land, would only, if anything, try shorting it, since his buy analysis was obviously faulty. But back to our story, which is not the story of anything remotely resembling “smart” trading…

…You got stopped out at 1.7041, the market went as low as 1.7037, but then quickly, within minutes, popped back up above that 1.7042 minor pivot support line. Heeeeerrre’s where you start getting stupid and beginning the Death Spiral: You think, “I was right, I just should have set my stop lower.” Of course that’s not true, but you’ve lost your mind, so what concern do you have with any sort of simple thing like reality? So you buy some more Gbp/Usd at 1.7044, this time setting your stop just below the new 1.7037 low. And you get stopped out. Undaunted, after it makes a new low at 1.7031, you buy it again at 1.7038 – even though the nearest support line now on anybody’s chart is 1.7020. Stopped out again, new low 1.7025. Despite the fact that you’ve watched Gbp/Usd do nothing but make new lows for a couple of hours, you stubbornly remain convinced that your original analysis that said “buy” (25 pips higher) was right. So now you’re buying it yet again, and you’re doubling your position size, because you just “know” it’s going to go up now.

 

Second Scene – Shots Again

Bang – stopped out again, for a substantially larger loss. The new low is now 1.7021, and you think to yourself, “Heyyyy, we’ve hit that next support level – THAT must be the bottom!” (Nope, it’s not.) When price goes back above 1.7042, you really “know” you’re right – you buy back in at 1.7046.

Well, to make a long story a bit shorter, the eventual low was way the hell down around 1.6960, or about seven or eight huge losing trades later. By the time you reach there (and Gbp/Usd has in fact finally bottomed out, and would be a great buy at that level), you’ve got maybe four dollars left in your trading account. What started out as just one simple losing trade has spiraled out of control and completely wiped out your account.

 

Third Scene – Stop the Bleeding

What’s the answer? How do you avoid this insanity and massive loss of capital? Easy, but easier said than done, because it involves consistently practicing the virtue of self-discipline in your trading. There are three cardinal rules of disciplined trading which you must always follow. The first is to have a set level of “stop the bleeding” daily drawdown – 5%, 10%, 20%, your choice – which, if you reach, you will shut down your trading platform and do no further trading for the day, period. I cannot stress how critical it is to your trading success to have such a rule in place, and to always religiously abide by it. The second rule is to cut your losses short, forget about them and move on – losses happen, don’t let a small one grow into a huge one. Finally, realize that you’re not always going to be right in your market analysis, and just accept the fact. Do not fall in love with your own opinion – be willing to immediately toss it in the rubbish bin as soon as the market says “You’re wrong”. If you can follow those three fundamental trading rules, you can avoid the Death Spiral.

 

Conclusion – You can do it!

Traders have a bad habit of falling in love with their market opinions and following them right down into a financial grave. They refuse to accept losses, they stubbornly cling to mistaken market analysis, and they don’t follow a strict “cut off for day” rule. This often leads to a Death Spiral of bad trading that wipes out one’s account in an astonishingly short period of time. The answer to avoiding this particular trading horror lies in simply practicing self-discipline and strictly abiding by some very basic, fundamental trading rules.

• Never follow up a losing trade by immediately taking the same position (buy or sell) in the same market again; Your analysis was wrong…and it’s still wrong

• Accept reality! If Gbp/Usd has been doing nothing but going down all day long, it is not at all likely to begin having an up day as the trading day draws nearer to a close. Don’t fall into the refrain of “Oh, THIS must be the bottom!” You know what? – If it’s made 3 new lows on the day, odds are it’s going to make 4.

• Stop the bleeding! Have a strict maximum daily drawdown rule – If you hit that level of drawdown on the day, shut it down, do no more trading that day

• Finally, just pay attention – to both the market action and your trading. What ultimately kills a lot of trading accounts is failing to just step back for a moment, in time enough to realize, “Wait a minute – what I’m doing (A) isn’t working, and (B) makes no sense whatsoever!”