Taking Your Lumps: How to Properly Manage Losses

[RichardCox 10]

Taking Your Lumps: How to Properly Manage Losses

 

One problematic characteristic that typically exemplifies the mentality seen in new traders is the sole focus on gains and the minimization of losses. These types of behaviors are not entirely surprising, given the fact that we do get into the trading business in order to make money -- not lose it. But what might not be readily apparent early on is that the only way to make sure that your account balance is growing is to properly manage your losses and not disregard the effects those losses will have on your broader averages.

 

The fact is that losses are inevitable, and that it is simply not possible to trade without seeing some negative trades. In fact, there are many successful traders that lose money in a majority of their trades. But how is this possible? How could a trader that sees losses more than 50% of the time be successful? The answer lies in the fact that these trades earn much more in their positive trades than they lose in their negative trades. In short, these traders are able to properly manage their losing positions.

 

Accepting the Reality of Trading

 

First and foremost, we have to accept the realities of the market. Losses are unavoidable, and a single loss can erase multiple gains if not managed properly. Consistent profitability requires an accurate assessment of how each structured trade will impact the trading account. Common errors are made when traders hold onto a position too long, hoping markets will reverse and the trade will return to break even. But this mentality breaks the first rules of trading because there is no way to hold off losses indefinitely.

 

Unexpected Impact of Holding Losers

 

While it might seem like a great idea to avoid losses at all costs, losing positions will often build because of the underlying momentum in place in the markets. If you took the position in the first place, you probably had an argument for why an adverse move would be unlikely. Furthermore, you were probably not alone in your assessment and when prices moved too far too fast, all of the traders in that were wrong are not being forced to exit their position. This only adds to the markets momentum -- and compounds your losses in the process.

 

For these reasons, there are situations where a string of gains is actually bad for the trading psychology, as this can create a set of unrealistic expectations. If you actually start to think that all of your trades can be successful, you will be less likely to close trades at a loss. If you refuse to accept the reality of the market, it is not out of the realm of possibility that a single trade to destroy your entire trading account (depending on your leverage and position sizing).

 

Is Your Strategy the Problem?

 

In many cases, losing positions have nothing to do with flaws in your trading strategy itself. You could have a perfectly sound system that is accurate most of the time, but just did not fit current market conditions. Your job is to spot the instances where the market’s price behavior does not match the strategy -- and then take your lumps and cut the trade. If you do not follow this mindset (and learn how to lose) your chances of achieving long term profitability are almost non-existent.

 

Prediction vs. Probability

 

Another mistake traders make is thinking they can know for certain where markets are headed. But could this same mentality apply to any other aspect of life? Can you be certain the Dodgers will win the next World Series or that next week your city will experience a snow storm? Of course, the answer is “no,” and trading is no different. What you can do in these situations in determine your forecast with some level of probability. Are there good odds the Dodgers might win the next World Series? Perhaps. Is there a strong chance your city will see snow storms next week? I think we are now starting to see the appropriate mindset.

 

Averaging Down: Adding to Losing Trades

 

Another issue occurs when traders discuss the “opportunity” to add to losing positions at the preferable prices currently seen. This is also referred to as “averaging down,” as it allows you to improve on your overall entry price. It must be remembered, however, that you are adding to your position size in the process and that if prices continue to move against you, the losses will actually be larger than they would have been if you did nothing. To be fair, averaging down can help in some cases and even turn your loser into a winner. But this doesn’t mean that it is always a good idea.

 

The real issue is whether or not market conditions have turned. If you plan on averaging down, you will need some fundamental or technical reason for why you believe prices will turn back into your favor. Without this, it does not make sense to average down and the position should just be closed. As a basic example, let’s assume you entered into a long trade in the EUR/USD because it was in an uptrend. If prices start falling, breaking important support levels, and failing to post new higher highs and higher lows -- your initial reasoning behind the trade has been removed. This would not be an instance where you would want to average down.

 

Watching the Data

 

There have been many published studies that show traders actually win a majority of their trades. So, why are most trading accounts closing with margin calls or $0 balances? To answer this, we have to take a look at our account histories and look at the specifics of each trade. Essentially, this means that your trading “batting average” is not everything. The proportional value of your winners and losers is what really matters. On average, if you win 9 trades that earn $10 each, and then have 1 trade that loses $100, you will not have a future as a trader.

 

Rules to Remember

 

In addition to all of these factors, traders must always remember to have an active stop loss in place. While this might seem overly basic, there are many traders that try to use manual stops or will simply close out a position when they “feel it is necessary.” This is not good enough, and these practices can put you in positions where your losses have accumulated faster than you expected. This creates a snowball effect where you might be reluctant to accept the reality of the situation and close the trade at a loss. Stop placement should be automatic, and no position should be left open without one. This does not mean the stop loss cannot be moved later, it simply means that you have defined a parameter where market activity could invalidate your initial rationale.

 

Methods for closing your position can come from a variety of different strategies. Many traders use significant support and resistance levels as an area to define when to get out of the market. In other cases, traders use technical indicators (such as the Average True Range) or set a position limit relative to their account size -- for example, never risking more than 2-3% at once. Closing your position does not have to be based on such hard and fast rules, however. Instead you could base things more closely on your strategy (as in the uptrend example discussed above).