Shades of Gray

Emotional decisions are inevitably stupid decisions. They're the extremist, myopic, "all-or-none" stuff that clouds your judgment and costs you money. Our emotions make us want to buy every bottom and sell every top, but in my experience the most prudent changes in allocation are the gradual ones.

What really matters isn't whether you own a stock, but the degree to which you own it. That's something you can easily lose sight of in all the media coverage devoted to some pundit or other's stock picks, or on sites that rank stock pickers and analysts: They've mistakenly reduced trading to an all-or-nothing affair. You're either long or short XYZ...end of story.

Successful traders know that the trinity of "buy, sell or hold" is only part of the game. There's a difference between managing a position, and just having one. The market, like our lives, isn't composed merely of black and white, but shades of gray.

As we've discussed before, it's quite possible to buy the top and live to tell the tale because of the importance of position size. Essentially, it's OK to be bullish on XYZ, but to put 20% of your portfolio into XYZ at a single price is just plain crazy. The same gradual approach we outlined in building a position should be used in managing it as well.

Just like seasoning a soup, most of the trades you make should involve relatively minor adjustments to your portfolio — not big sweeping overhauls. When traders get emotional, they tend to overallocate. If they're bullish...they get really bullish — same goes for when they're bearish. Either way, the ego gets in the way and they create a do-or-die scenario: Either I'm right...or I'm dead. A black-and-white solution for a gray question. While it's important to learn to take losses, that doesn't mean you have to take them all at once. Sure, the market moves in trends over longer periods of time. But in the short run, stocks fluctuate. It's just what they do. Without a gradualist approach to managing your positions, you can be right about the long-term trend but get slaughtered by the short-term fluctuations.

So let's say you're long 1,000 shares of XYZ and want to get out. Maybe the stock has been downgraded by a major investment house or moved below a key technical indicator. Maybe there's another stock that's caught your eye or you want to hedge. Maybe you lost your job and need to be more liquid. For whatever reason, you want out of XYZ. Fine, time to sell XYZ. Instead of dumping the entire block, watching it rally and then kicking yourself for your "bad timing," start by taking steps to reduce the risk, not eliminate it. If you're long 1,000 XYZ and want to sell, sell 250. Sell 500. Sell 600 if you're really queasy. But average out of the position, don't jump out all at one price. Even though emotions might be flaring, turn the situation from an "all or nothing" into a slightly more conservative "just something." Another example: Let's say you buy XYZ and it drops 20%. Would I sell it all? Probably not. But would I double down? Not a chance. Again, the point is that your response doesn't have to be all or nothing. From a trader's perspective, prudence dictates that you would at least reduce your exposure. If the stock rallies back, you're still in the game. If it drops further, you've protected some downside. You're respecting the trend, not resisting it or fully capitulating to it.

Emotional thinking is irrational thinking. When the market moves, it's tempting to make big bets, but the best trades are those that shift a portfolio, not shred it. By reducing and increasing exposure to XYZ gradually, you can manage the position's risk with considerably more prudence than larger trades would afford. On Wall Street, gray isn't the new black or white, but the classic color that never goes out of style.

It's true that there's a downside to this incremental approach: It entails more frequent trading. And with more frequent trading comes higher commissions, which can make such active strategies prohibitively costly for smaller portfolios. But there are techniques to game the markets no matter at what level you play. From rolling CDs to writing options, we'll discuss the games traders play one week from today.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund.