Continuing on a reflective vein, I’d like to delve into the Higgs of trading/investing. What is it that holds successful traders/investors together? That might seem somewhat ambitious to begin with, so I’ll settle for a more modest inquiry ~ how do traders self-sabotage?
In the previous two articles, we talked about using stop losses to stay in the game long enough to turn profitable. We also talked about the insidious nature of stop-losses ~ taking too many of them could bleed your account dry before you turn profitable. In this article, we focus on the flip side ~ the fact that cutting your winners too quickly will lead, inevitably, to the demise of your trading account.
Dealing with your winners
As we develop as traders, we learn (hopefully!) to cut our losses quickly. It’s like a deliberate psychological lesson we teach ourselves. As a position moves beyond the point we’ve previously demarcated as the "pain point", a voice comes on in our heads repeating, somewhat monotonously, the need to look for an exit at the most favourable price possible. And over time, we become quite good at it.
We accept the fact that this is a numbers game: you have to keep playing on the hypothesis that your statistical edge will pay off in the long-run. So you’re ok taking those small losses in the hope that the (big) wins will more than compensate for the losses and actually make the effort worthwhile.
It is said that the main cause of failure among professional traders is not the small losses that they take but the small winners. They lose because they cut their winners too quickly. This means that their winners and losers are roughly the same size. Factor in the drain of the commissions, slippage, establishment costs (Internet, software etc) and you can see there’s no room for a living in there.
We’ve all been there. Suppose you operate on the basis of a two-point stop and a four-point profit target in the product you trade. You have a string of three successive losses with a particular setup. That’s nothing unusual, as we saw last fortnight.
Then your fourth trade starts turning in your favour. It moves two points in your favour and pauses. You panic.
Rather than let the trade work its way either to the profit target or the stop, you take yourself out of the trade for a small profit. And then you watch miserably as the market reaches your target or feel relieved if the market moves the other way and takes out what your stop would have been.
Either way, we’ve lost. We’ve lost because we scuttled our statistical edge ~ the premise of trading success. We prevented the law of large numbers from working its magic. We interfered with the lab experiment we talked about last fortnight. Do we count this fourth trade as a winner or a loser?
Suppose your trading plan dictated that after four successive losses with a given setup, it would be withdrawn for further diagnostics. One could argue that if the market would have gone on to hit your stop, one could have considered this a loss and, yes, withdrawn the "product".
The fact remains however that you’re tampering the experimental procedure with your "could haves, should haves, would haves". How much confidence (and motivation) can you muster in preparing the experiments if you know, in advance, that you’re going to violate them anyway?
The Higgs boson
I suspect that the non-violation of experimental procedure is the key particle that separates the successful traders from the unsuccessful ones. It is not a question of how much the trader is making: it’s how disciplined, resolute and consistent she is in applying the process.
Her trading goals are not money-centric: she does not have a monthly or annual dollar target. She grades herself on the basis of how well she follows her trading plan and executes her setups. Strangely enough she also seems to make money ~ lots of it!
Notice: Trading options involve substantial risk of loss and is not suitable for all investors. You may lose all or more of your initial investment. Information shared here is for educational purposes only.
The writer is managing partner of a financial engineering company based in Italy. He can be reached at email@example.com