How Not Losing Keeps You From Winning in the MarketsBy Cory Mitchell, Cmt | 15 April 2010, 10:01 BST
Cory Mitchel, VantagePointTrading, CMT
Losing is inseparable from trading. Losses will occur, and trying to avoid losses can be the demise of many traders – on all time frames. Whether someone is a day trader or an investor, not accepting losses is a recipe for disaster. Great traders know that losses occur, but they plan for losses and have an exit strategy for when losing trades occur. This exit plan is critical, and failing to have one is where most traders end up going wrong in their trading careers.
Humans have a tendency to want to avoid losses. In terms of trading this often results in an inability, or a seriously delayed reaction, to realizing a loss. Losses are allowed to remain in an account and the trader shifts into “hope” mode. The “hope” mode results from the trader wanting to get back to even, because if that does not occur (getting even that is) a loss must be realized.
In “Beyond Fear and Greed” by Hersh Shefrin a study is discussed where people generally view a loss as having 2.5 times the impact of a gain of a similar magnitude (24). In other words, a $1000 gain is one thing, but a $1000 loss in psychological terms feels more like a $2500 loss. This is not unreasonable to fathom. Being wrong carries an impact on the ego, not to mention losing money we have means we forgo an opportunity to use it for something else. Money you make is money you didn’t have anyway, but money you lose is money you already had and no longer have. This stings, and is a valid psychological reason why traders don’t want realize their losses when they should.
Losing Means Winning?
Trading profits are always based on the ability of the trader executing the trades. Yet, successful traders don’t let losses get out of hand. They are not afraid to take a loss, and in fact they will likely realize many losing trades because they have a low tolerance for trades that don’t react or move how they expect.
In this way, taking losses actually does mean a trader is more likely to be profitable. “Realizing” a loss simply means the traders closes out the position – the loss (or profit) is booked in the account. Not realizing a loss or profit simply means the position remains open and is susceptible to further movement.
If a trader exits when they are supposed to it shows the market did not react how they anticipated and thus there was no reason to remain in the position. A trader who allows losses to mount is no longer in control of their trading, and they have entered a gambling mentality. The market has shown them they are wrong but they are not listening to the signals. Instead they have opted to not realize a loss; not accept they were wrong. As discussed, there are psychological reasons why this occurs, but regardless of the reasons not accepting a loss, and letting it continue to mount, will most certainly result in frustration and a lack of profits over the long run.
A Psychological Trick
Those who are struggling with their trading may have a hard time admitting that they are to blame. Rather it is “The markets fault.” There are endless excuses for why losing trades occur, but ultimately the buck stops with the person executing the trades. The faster we accept this, the quicker we will learn to minimize losses and the more profitable trades we can become a part of.
This is where a psychological trick comes in. Not only are losing trades losing us money, but the longer we hold onto those trades (and tie up capital) the more opportunities we give up to get into profitable trades. Thus losing trades deal us a double blow and should be booked as quickly as possible so we can move onto other opportunities.
Stock brokers, are often taught not to tell their clients to “Exit that losing position.” Rather the broker is taught to tell their client something like “We need to transfer you funds into something which is better opportunity.” Avoiding the “loss” discussion and instead using words like “transfer” makes closing out an unprofitable trade much more palatable.
Just as stock broker may convince a client to get out of a losing trade by changing their language, individual traders should also do this. Try not to think in terms of winning and losing on trades, because both will occur regardless of belief or trading system. Rather the trader should focus on transferring capital into best performers.
This does not mean someone has to continually be trading (over-trading). It simply means that any time a trade is made the trader knows when they will exit. When the situation develops, the loss is booked and the trader can focus on moving funds into other opportunities. This transfer is what matters, getting out of a trade simply allows that transfer of capital to occur.
Losing trades not only strip a trader of capital, but if a trade is held longer than needed other opportunities may be missed. Therefore it becomes imperative that a trader be willing to realize losses as soon as required so that they can move onto other opportunities. There many reasons why losing trades are not exited and allowed to mount, but ultimately it is the responsibility of the trader to be in control of how they trade the markets. Traders can benefit by not thinking in terms of losses or profits, but rather simply thinking in terms of “transferring” funds from one opportunity to another.
Cory Mitchell is a full time trader and is widely published. He is the founder of http://vantagepointtrading.com and head of training at his proprietary trading firm.