Sunday, October 28, 2012

Dealing with a losing trade

Historically, trend following strategies have been built on the premise that, although you may lose on the majority of the positions you take, the size of your winning trades you have is much greater. It is this that creates the overall positive expectancy of the system. This is quite a difficult picture for inexperienced traders to get their heads round - how can you make money if you lose on most of your positions?
Trend following can only work if you are able to ride the winning positions all the way until the trend ends. If you find yourself taking the easy way out and banking profits early, fearful of losing those profits, then the overall expectancy generated by the system will not be as intended, and you will be destined to fail.

What is also an unknown factor is the order in which the positions you take will generate your winning and losing trades. It is quite possible in choppy, volatile markets for a trader to suffer a run of losing trades, and suffer a drawdown. It is one of the reasons why having appropriate risk limits, both on each individual position as well as with regard to your overall portfolio, is critical to achieving long-term success (refer to the recent posts here and here).

Below is the chart of UK stock African Minerals, on which I opened a long position a few sessions ago. This started moving in my favour on the day I opened the position, only for the price to do a quick about turn and stop me out within a few days for a 1R loss. Now, I could have kept my position open (and overriden my stop) in the 'hope' that the price would reverse back upwards and eradicate my loss. But no, I honoured my stops and took the loss. Which is what any trend follower should do.

Again, this goes back to the theory that you cut your losses short, and let your profits run. I saw a long set up, which failed. It happens. You need to have the emotional strength to put it to one side, treat it as a cost of doing business, and move on. This is obviously easier to do if you allow yourself to have the 'emotional indifference' on each trade, which only comes from having your risk parameters at prudent levels. All I know is that, with every losing trade, I am closer to a winning trade, and maybe a big one at that. So, I keep my losses small, minimising the damage to my equity, and keep looking for good set ups.
Remember that historically, some of the most successful trend followers have made their fortunes while winning on less than 40% of their trades. As Bernard Baruch once famously said "If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong."

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