Thursday, March 06, 2014

Learn to love taking losses

I love taking losses - being able to accept you have been proven wrong on a trade is an important skill to learn, which I guess it the opposite of what 90% of traders like to do. Why is this?

It is almost a challenge to cut losing trades as quickly as possible, and to minimise the impact on your funds. Capital is the lifeblood of a trader, so any reduction needs to be kept as small as possible.

Due to the way I calculate my initial stop distance and position size, the average size of my losing trades is significantly less than 1R (i.e. being less than what I was prepared to risk on the trade).

Generally, I want my trades to go into profit within 24 hours of opening them. If they do, then all well and good. I can reduce my risk at that point and start to utilise my trailing stop methodology. If the trade does not act as anticipated, and falls below my trigger level, then it is cut, and I move on.

I guess my own method differs from most traditional trend following systems, which can allow initiated trades to fall back to a full 1R loss before being stopped out. I would rather cut the position at say a 0.3R or 0.4R loss, and if I get another signal in a few days, then may be look to re-enter. In compounding terms, one or two traders I know are adamant that this aggressive cutting of losses is our edge, due to the impact on the compounding of equity over time.

This cutting of losses in this manner is logical to me and something I feel 100% comfortable in doing.

Of course, there are occasions where it is possible you can get whipsawed around, and if you are not careful, you can incur several small losses on the same stock or instrument on a short period of time. But that is a price I am willing to pay. I eliminate the possibility of a big loss coming my way.

When confronted with a losing position, what most losing traders do is hang on, hoping that the trade will turn around and move back in their favour. If you see a loss on a position, then whatever your reason for entering the trade has been proven wrong at that time. The simple fact that you are confronted with a negative figure on your P&L should tell you that! If you are too rigid in your opinion, or by refusing to take the small loss and move on, then that is how small losses can turn into bigger losses, causing significant drawdowns or even account blow-ups in extreme cases.

To correct this, you need to develop the attitude of being comfortable in taking small losses, and accepting that a lot of your trades don't work out. Most trend followers are proven wrong on more than 50% of their trades.

Finally, you can get a great psychological bonus by aggressively cutting losses in this fashion. Every morning, when you open up your trading platform, all you should see is your existing, profitable trades. No nasty losses confronting you. And those winning trades should be left to run, maybe of weeks or even months, until the trend finishes and your trailing stop is triggered.

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