Cutting Losses and Letting Profits Run

[RichardCox 10]

One of the most common problems that traders of all experience levels inevitably run into on a fairly regular basis occurs when we fail to cut losses quickly and allow profits to run to their full potential. Anyone who tells you that they are able to avoid this problem is either significantly inexperienced or is just flat out not telling the truth. Often times, traders will close a profitable trade too quickly, as these traders are too excited to actually see a trade move in a profitable direction and there is the fear that the price will reverse into a loss at some later stage.

 

During negative trades, the reverse is often true: Traders will often hang onto losers too long, essentially hoping that prices will change back into their initially forecasted direction. These traders are afraid to close their positions because it will result in a guaranteed loss and they instead opt to wait for the lower probability chance that the trade will eventually see gains.

 

Accumulating Losses

 

Unfortunately, the result of this fear is that the losses accumulate (or even accelerate) and in many cases this type of behavior is what costs new traders their entire deposit account. As if these tendencies were not already bad enough, many of these long held losers do eventually reverse and would have returned to profitability at some stage, if the initial trade had be structured in a more responsible and logical manner.

 

Despite the basic nature of this problem, it is something that all traders (even the most successful ones) run into on a fairly regular basis. So, the question all traders should be asking themselves is – How can these situations be limited?

 

One key point to remember is that these negative situations do tend to be reduced with experience, so new traders should not feel overly panicked. What does need to be understood is that losing trades are inevitable. They happen to all of us. They key is reducing their impact relative to our long term gain percentage. All traders need to be equally willing to accept both gains and losses as they relate to your initial trading plan, not as they relate to your emotional response to seeing prices work for or against you. A big part of this removal of emotion comes from not risking more capital than you can afford to lose. If your trading losses will not materially affect your lifestyle, it is much easier to be rational when deciding to close a losing position. Losses are an inevitable part of the game, and any trader that thinks this can be avoided is completely delusional.

 

Focusing on Probability, Not Emotion

 

Once the reality of the market is understood (nobody can predict market behavior, all we can do is isolate higher probabilities from lower probabilities), it is much easier to allow your original trading plan to work itself out to completion. Probability is really the name of the game and when these things are based on overall trend direction, or a break of major support or resistance, traders need to be willing to exit those positions once the original criteria become invalid.

 

These areas (such as the break down of a technical pattern or a reversal in trend) should be where stop losses are initially placed and rigorously obeyed, as prices moving to these areas were viewed as unlikely in the original trading plan. Trade sizes are another factor to consider, as higher probability trades can allow for larger position sizes, while more risky trades should be accompanied by lower risk exposure.

 

Once a trader has done the work to isolate higher probability trading scenarios, stop losses and profit targets generally become more obvious as most trading patterns (such as a head and shoulders or flag patterns) have specific price projections that can be used for determining trade parameters (ie when to exit a position, either for a gain or a loss). Once these parameters are set, obey your rules and let the trade work to completion. While there might be times when parameters need to be adjusted, the original trading plan is usually the best and alterations tend to be based more on emotion rather than statistical probability. This, needless to say, needs to be avoided as much as is possible.