The Second Trade

Throughout most of my life before Technical Analysis I was a baseball player. I guess once a ball player, always a ball player, at least psychologically. I often find that a lot of the habits I picked up over the years on the diamond have given me a huge advantage during my professional career. We can talk about the patience necessary as a hitter or even out on the field playing defense. We can get into preparation; what are you going to do with the ball if it gets hit to you? This depends on how many outs there are, how many runners are on base, the speed of those runners, etc. The work ethic that it takes to be prepared for a game, the running, the lifting, the stretching, the long hot practices, the early morning runs in the snow, the mental toughness that it takes to get through all that, just to be ready for game time. A lot of these traits can be developed in other sports as well. But today I want to talk about one thing that has really helped me as a market participant, and that's the art of pitching.

Growing up, I was always a combination middle infielder and pitcher. But once I got into high school, the coaches sat me down and said, "JC, you're just a pitcher now, so we want you to focus on developing your arm strength, control, and improving your breaking balls". I loved pitching, so I was okay with that. Unfortunately I wasn't exactly blessed with a golden arm. At my peak I was topping out in the mid-80s, and that was with the wind behind me and at top physical shape (which some might argue was never that impressive, relatively speaking). So I had to improve on my strategy, the mental aspect of the game. I had to be smarter than the hitter, and try to fool him and frustrate him as much as possible in order to gain an advantage. One of those methods was the setup pitch. If a big powerful left-hander came up to bat, for example, I might start him off with a fast ball high and tight to back him off the plate and then come in with a change up that broke down and away. Other times I might start off a hitter with consecutive curve balls and then come at him with a high fast ball. This would make my fast ball appear much harder since it was coming off back-to-back breaking balls, that typically have less velocity. But the lesson here is that I was always thinking about the next step. The initial pitch often was really half the process, whereas the following pitch was the more important one.

This is one of the most important and underrated parts of the process. As market participants there are two major actions, initiating a position and then exiting that position. The latter often gets lost in the mix due to some of our flaws as human beings. Our dopamine fix comes when entering the trade. Getting out can, more often than not, be less exciting. So we need to combat that by predetermining our game plan for the second trade. This is the more important trade after all. In fact, the initial position should only be entered once the second trade has been established. If we are buying a stock, Where are we selling it to the upside? (what is our target?) and Where would we get out to the downside? (what is the risk?). This should be determined, not only to have a game plan, but more importantly to decide whether the potential reward justifies the amount of risk being taken. Does that ratio between the risk and reward fit our investment goals, time horizon and risk parameters? Until we decide what the second trade will look like, there is no way to answer those questions, and therefore the first trade shouldn't even be entered in the first place.

I believe the concept of the second trade being the most important one can be applied to investors of all kinds, ages and time horizons. Everyone from a long-term investor to an intraday trader can apply this notion. When I'm initiating a position, what is the exit plan? Are we just going to hold on to this stock forever? Or are we going to be short a stock and have an unlimited amount of risk? I think both of these can have very painful outcomes and this derives from lacking a plan. Without knowing how much risk you're taking, how can you decide whether or not this is the right move to make? Without knowing what your upside target might be, how can you know whether the potential reward justifies the amount of risk being taken. If you're risking the same amount that you can potentially make, why don't you just flip coins with people for a living, where you constantly have a 50/50 shot? At least this way, you can constantly quantify the risk vs reward. It may not be optimal, but at least you know what it is.

The market is a special place. We can sit there all day every day being patient enough to wait for only the most optimal risk vs reward opportunities. Regardless of what our strategy might be, finding scenarios that meet our goals and objectives is the only thing that we can really do. But without recognizing and defining our second trade, how are we able to come to that conclusion. It is mathematically impossible.

So when you hear someone pounding the table on a given name, regardless of whether it is a stock or bond or commodity or currency cross, don't worry so much about where his/her entry point is or the reason why they like it. The reason doesn't matter for the purposes of this conversation. The most important question to ask is, "where are you out?". In other words, where do you think it's going and at what point do you recognize that you're wrong and it's time to take the loss and move on?

The second trade is the important one. It might not be sexy. It often gets completely ignored. But it is the most important decision you'll make before even entering the first trade. Without knowing what the exit will be, how can you possibly decide if it's worth the entry? It's not possible.

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