Wednesday, May 08, 2013

Cutting losses

Given how a trend follower approaches the market, where they could suffer losses in more than 50% of their trades, to create their positive expectancy they need to ensure that the winning trades are bigger than the losses incurred.

When a trend develops in a position, then a trend follower will keep that trade open until they get an exit signal, signalling that the trend has finished. Just as critical, it is imperative that the trader has no qualms about cutting a position when it does not act as intended, or an initial stop level gets breached. 

They know that their system has an overall positive expectancy, and they also know that they will occasionally get themselves into a trade where a significant trend can develop. That trend will cover a lot of small losses and still leave some residual profit, generating the overall positive return. 

This approach only works providing they remain consistent and do not get emotionally attached to a losing position, or start to allow of small loss to develop into a bigger loss by overriding a stop level.

One thing I have noticed is that a lot of people generally get into trouble as a result of one or two large losses that have got out of control, which cause a big drawdown to their equity.

I've had some correspondence recently with a couple of traders about how quickly I cut losses. I don't think I've ever placed a trade (even back when I very first started trading) without placing a stop. If it gets hit, it takes me out of the trade and I move on. These days I cut my losses even quicker - if a trade does not act as intended after being opened, I quite often cut the position within 24 hours - sometimes even within the same trading session, and these are closed with a loss somewhat smaller than 1R. Ideally I want my trades to be in profit from day one.

Instead of having a position drift against me and trigger a 1R loss somewhere down the line, if I can turn some of those losing positions into say a 0.2R or 0.3R loss, then over a period of time that will have a significant impact upon the overall expectancy I can attain.

Don't just take my word for it - as Ed Seykota said in his Market Wizards interview:

"The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance."

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