Most traders and investors at one time or another have fallen into the “confidence” trap. Sometimes it’s a result of believing in the infallibility of their research. Other times it’s due to having a presumed “hot” hand — they’ve finally got the game figured out and can do no wrong. Maybe they’ve gotten caught up with some hot new money-minting trading system with a great historical track record. Or perhaps they’ve been drawn in by someone else’s hot streak, in a chat room for instance (novice traders, trying to skip a few steps, are notorious for succumbing to this). All the calls turn out great, and even the fundamental and technical research that’s shared always seems right on the money. However, up to that point they’ve just watched –- and they’re kicking themselves for missing out on yet another huge gain. Let’s take our fictional trader and call him Bernie.

Bernie decides he’s not going to miss out on the next opportunity that comes up. When the next “hot stock” is revealed, it happens to be a stock that he himself already had on his radar. The additional research backs up his conviction. Everything seems right, and the stock appears perfectly poised for a huge move. Bernie’s confidence level for the trade is higher than ever. Forget about what he can afford to lose, this is the trade that’ll make his year!

Bernie decides to accumulate a position much larger than normal — 3 times as large in fact, equating to about a quarter of his total account size. At first, all seems to be working out great and the trade has even moved a nice 5% in his favor. Two days later however, he wakes up to find the stock down 25%, blowing right through any stop levels he may have considered. The company out of the blue announced a dilutive secondary offering to “better take advantage of opportunities that may become available” or some other similar mumbo-jumbo.

Bernie feels caught, but he figures the big picture still hasn’t really changed, and that prices should find support around the offering price. In fact, he decides to double his position around the offering price if he can. The company’s valuation seems cheaper than ever, and the company will now have even more cash to materialize its goals.

However, as the price continues to drop, Bernie starts to wonder… More investors, increasingly disgusted by the management’s apparent lack of regard for their investing well-being, decide to throw in the towel. By the end of the week, the stock is down another 38% just from the offering price! The same stock that traders and investors all loved at $9 just a few days earlier, they now hate at $5. Even those investors who bought into the secondary are feeling completely betrayed.

Ironically, if the research and valuations are accurate, the stock should be more attractive than ever at these levels. Of course, it doesn’t matter anymore, as most traders (including our newbie trader Bernie) decided to throw in the towel as the stock sells off in a panic around $4/share leaving Bernie with a whopping 44% account loss (requiring a 125% increase in account value just to reach breakeven). Several days later, the stock is trading back around its offering price. How’s that for the perfect reaming. Bernie feels crushed, blames the guy in the chat room for putting out such a horrible call, and calls him a fraud despite the fact that all his other picks turned out pretty well.

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