Thursday, January 26, 2017

Controlling your losses, good trades and bad trades

Good traders continually worry about trying to minimise any potential downside. By the same token, they try to avoid placing any restrictions on the potential upside.

Take the four possible scenarios on any individual trade: 

  • Big win; 
  • Small win; 
  • Small loss; and 
  • Big loss. 
Good traders try to avoid the big losses at all costs. If you have a robust trading approach that has a positive expectancy, then the small losses can easily be recovered from.
Big losses, however, can create significant dents both in your confidence and your trading equity – and in extreme cases, big losses may result in your account blowing up.

Therefore, keeping your losses as small as possible helps ensure you stay in the game.

"If you lose all your chips, you can't bet" - Larry Hite

So, how do you try and minimise the size of your losses?

There are three elements to this: 
  • Risk only a small amount of your equity on each trade; 
  • Ensure that you use a stop level to get you out of the trade as soon as price has shown you that you are wrong (based on your trading rules and methodology); and 
  • Calculate your position size based on the difference between your entry level and your initial stop level, this being the amount you are prepared to lose if your stop gets hit. 
Even then, there are still possible 'price shocks' which can occur - it is possible for price to gap through a level where your stop is placed. A good example of this is if price drops overnight to below your initial stop level after an earnings release or a profit warning.

In those scenarios, you will lose more than you intended to risk. So that possibility (no matter how remote) should also be factored into your trading plan.

On the face of it, those elements should be pretty easy to understand and implement. But they aren't for everyone.

The psychology involved in trading can make it difficult for some people to avoid taking excessive risk, or overriding their stops. Someone may have given you a 'hot tip' or talked about a 'can't lose' setup, which may be completely at odds with your own entry criteria - it almost lures you into overriding your rules or risk control.

Some people may start trading certain instruments where you are unable to adhere to all of those elements. To take the trade, you are forced to place your stop too close to the current price, making you prone to whipsawing. Or maybe there are minimum position or margin requirements forcing you to risk more than you should.

Secondly, to add an extra layer of complexity to all this, it does not follow that only 'good' trades will generate profits, and only 'bad' trades will generate losses.

Okay - so what is a good trade? What is a bad trade?

Basically, a good trade is where you have: 
  • taken an entry based on your own rules or criteria in terms of identifying a setup; 
  • executed the entry at the right time and price level; 
  • used appropriate stop placement and position sizing; 
  • exited the trade in accordance with your own exit rules. 
Therefore, if you are able to follow those steps, then it should be considered to be a good trade irrespective of whether it ultimately generates a profit or a loss.

A bad trade would be where you are breached any (or all!) of those points. Yet it is also possible that a bad trade may generate a profit!

Why is this?

Well, we know that, once you are in a trade, it is the buying and selling actions of other market participants which will affect price, and therefore determine whether it moves in your favour or not. This is something you cannot control.

As a result, you can therefore end up with a myriad of outcomes which may have resulted from either being deficient in things YOU control (your execution, risk management, good or bad luck, or psychological issues such as a lack of patience or discipline), as well as things over which you have NO control (the buying and selling actions of others).

In other words, on a sample size of one, each individual trade is a coin toss as to whether you make a profit or loss.

Finally, it is possible to control your risk, cut your losses etc, and still lose over time if your method does not have a positive expectancy over a large sample of trades. This is what is known as the 'death by a thousand cuts'- you can faithfully follow whatever rules you have, but you suffer from a slow erosion of your equity.

Of course, even the most profitable methods can have periods of non-performance. As I explained in this post, some of the most successful trend followers have suffered drawdowns of a year or even longer, as the various markets they trade go through trending and non-trending phases.

Despite this, assuming that your basic method has a positive expectancy, the more ‘good’ trades you can take, executed in accordance with your own rules and with good risk management and position sizing, the better your long-term results will be - while also reducing the risk of those big single losses, drawdowns or blow ups.

Again, we will leave the last word to Larry Hite:

"The important point is that if you do enough of those (good) trades or bets, eventually you have to come out ahead."

1 comment:

  1. Again a top post, Steve! Thanks a lot and keep up the good work!

    Christoph from Germany!