Talking Points:
-Losing is an inevitable part of trading
-One loss can wipe away numerous gains of many winners
-Traders need to learn to lose properly in order to find consistent profitability
The only thing that a trader can ever really be assured of is the fact that they are going to take losses. It’s an inevitable part of the game.
Most new traders try to avoid this, and they try to manage their losing positions in the hope that the trade might come back to break-even – if only so that they don’t have to see a loss.
But eventually, it almost always works out the same. One of the losing positions that the trader is trying to manage gets away from them… and the loss becomes much more than they can bear.
This loss can more than wipe away any gains that the trader may have seen, and eat deeply into their equity, and perhaps even put them out of trading altogether.
I have seen traders allow just one bad trade to literally eat away almost every dollar of equity in their account. It doesn’t matter how great of a strategy this trader had, and no matter how well-heeled his plan may have been; if you can’t manage your risk your hope of consistent long-term profitability is limited, at best.
In trading, you have to learn to lose before you can ever truly win. In this article, we teach you how to lose properly.
Why is losing necessary?
Point blank – you don’t know the future. Neither does any other person on the planet Earth.
This doesn’t mean that you can’t forecast price movements; millions of people do this every day through banks, hedge funds, and as retail traders. But rather, you have to see each trade as an idea, or an opportunity; and like many opportunities in life, this idea simply may not work and you have to be able to do the correct thing when you get to that point.
And the only correct thing to do when you realize you are wrong is to cease being wrong and start being right! The way to be right is to close the position.
I know this can be difficult to close a trade that's already eaten into you; after all – if you liked the idea at your entry price, and it moves against you – the idea might look even better at a cheaper price!
This is the most dangerous logic in the field of trading. Remember hearing the stories about ‘The London Whale?’
He built up such a large position trading at one of the ‘Too Big to Fail’ banks, and as the position moved against him, he couldn’t come to grips with realizing the loss… so he bought more…. And then even more.
And the same thing that happens to most retail traders happened to one of the largest banks in the world. Losses in the BILLIONS were eventually taken, the bank was fined IN THE BILLIONS, and those traders may even be facing criminal charges in the not-too-distant future.
All because one trader couldn’t pull his fragile ego up to the point of admitting that he was wrong on one, simple idea.
This is The Number One Mistake Forex Traders Make. DailyFX looked at over 12 million trades placed by live traders on FXCM platforms, and found that in most currency pairs traders were winning well over 50% of the time. For example, in the below bar graph of winning percentages, notice that traders in GBPJPY were profitable a whopping 66% of the time! That's nearly 2 out of every 3 trades being closed out properly!
Winning Percentage isn’t everything
Taken from The Number One Mistake Forex Traders Make, highlighting GBPJPY
But, that nice winning percentage didn’t matter. Traders still lose money in GBPJPY. The bar graph below shows the average win (in blue) versus the average loss (in red).
Small wins and big losses rarely works out well
Taken from The Number One Mistake Forex Traders Make, highlighting GBPJPY
Notice that traders in GBPJPY lost well over 2 times (average loss of 122 pips) when they were wrong than they made when they were right (average of only 52 pips). This is not losing properly, and this type of management doesn’t allow the trader a very good chance of obtaining profitability.
How to Lose Properly
Losing properly may sound somewhat oxymoronic to the new trader; but I assure you, it is a necessary trait that WILL be learned by anyone that will eventually find trading success.
Otherwise, the potential to hit a land mine with that one idea that just doesn’t work out is always there; and eventually the trader will hit that land mine and blow up multiple small winning trades with just one big loser… just like we saw in The Number One Mistake FX Traders Make.
Always Use a Stop
The thesis of the number one mistake traders make is also the first step in losing properly. Always set a stop.
Anytime you open a position, setting the stop should take place directly after that. This should become automatic. Open a position – set the stop.
This means that you don’t have to scramble to decide where to cut the bleeding when you’ve realized your idea is wrong, which is never really a fun, positive experience.
This also allows you to set your risk at the outset of the trade. You can draw your proverbial ‘line in the sand,’ so that if your idea is proven wrong, you can cut it before the loss becomes unbearable.
This means that when entering the position, you can specify the maximum amount you would like to risk on this one idea. You can use a percentage of your equity, such as saying ‘I’m willing to risk 1% of my equity on this trade.’
You can then multiple your equity by ‘.01’ and that gives you a ‘stop amount.’ You can then take the stop amount, and divide this by your pip cost – and this gives you a stop based in number of pips from your entry.
We went over a couple of different ways of setting stops in the article, An Easy and Advanced Way to Set Stops, and any of these methods (including the % risk example above) can be used to draw that line-in-the-sand.
Average True Range can help in setting stops based on market activity
Image taken from An Easy and Advanced Way to Set Stops
Never throw good money after bad
After you’ve set your stop on the trade, you’ve defined the maximum that you are willing to lose on this idea.
After doing this, the trader’s job is to hold the line. That means that if prices move towards your stop, you DO NOT move it further against yourself, hoping that miraculously the extra stop distance you’re giving the position makes the difference between winning and losing.
If you move your stop deeper against you (giving the trade more ‘room’ to work), you’re essentially throwing more good money after an idea that has already shown you unfavorable results.
Why would you do this? You can easily employ that capital that you’re risking on the wider stop into an entirely new trade idea that has not yet shown you failure.
I see this time and again from new trader, simply unwilling to admit that they were wrong and it rarely works out favorably. Even if it does work out favorably once, or twice, the same thing in our initial example will eventually happen: The position will move against the trader until, eventually, the trader’s capital is exhausted on ONE BAD TRADE.
A further point to this is adding to positions. Many traders will add another position to an already losing position under the presumption that they are ‘scaling in.’
This is not scaling in. This is throwing good money after bad.
Scaling in is planned beforehand; and is strategic. In most cases, many professional traders are ONLY scaling into winning positions. I covered this type of logic in How to Scale in to Positions. This is position trading, and in my and many other trader’s opinions – this is the only way to properly build a position.
Traders want to look to scale in to winning positions
Taken from How to Scale in to Positions
If you add to a losing position, well the same catastrophe mentioned earlier will eventually erode your account. You might make it out of one or two trades successfully, but eventually you’ll hit that one that just doesn’t work – and as you’re increasing your trade size the position continues to bleed against you and erode your equity.
One simple trade idea eats a monstrous chunk of your trading account. This is catastrophe.
When you set your stop, do not move it against you. Do not add to a losing position.
Utilize Break-Even Stops
So, even after you learn how to lose – it is still going to stink. But eventually you become numb to the feeling. It always stinks, but after you gain some experience you begin to realize that it’s inevitable and just a cost of doing business.
One way that losing can be mitigated is through trade management.
A primary reason that so many traders would take such small gains and such large losses in The Number One Mistake Forex Traders Make is default human nature. Human beings are, for the most part, scared to lose.
Just think about the last time you were in a trade. If the position moved against you, many people think ‘well, I’ll let this one work to see if it can come back to my entry price. I’ll hang on for just a little bit longer, and if it gets to even a 5 pip gain I’ll close it out quickly.’
This is greed – when in fact the trader should be fearful (the position has, up to that point, been a failure).
On the other hand, think of opening your platform in the morning and realizing you have a small gain that didn’t quite hit your profit target. Most people will look at that and say ‘well, I’ll close it out just so this thing doesn’t move against me, and becomes a loser.’
This is fear – when, in fact, the trader should be greedy. This position has shown you success! You’ve been proven right! These are the situations where you want to let the trade work with the goal of taking more profits out of the market.
If you’ve felt this way, well – that's pretty normal. This ‘greed when you should be fearful,’ or this ‘fear when you should be greedy,’ is really just default human nature.
One way to begin to control this misaligned human nature is to use the break-even stop.
When you see that position that is in the money, and you are afraid to let the position work for fear of this winner coming back and becoming a loser – rather than just close out the position – you can move your stop to break-even.
Traders can remove the risk of loss while looking for bigger gains
Image taken from the article, The Break-even Stop
This way, if the trade moves against you, you can be taken out for no gain, and no loss. This can save you the amount you had initially put up to risk on the position.
Further, this can allow the trade to work while you carry a clean conscious that, at the very least, your initial equity is no longer exposed on the position.
-- Written by James Stanley
James is available on Twitter @JStanleyFX
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