How cutting your losers early can dramatically improve your bottom line
If we assembled a group of traders’ together in a conference room, ensuring they were all of different levels of experience and success and then we posed a few basic trading questions to them, the answers we’d receive back would be fascinating.
One critical question we’d ask would be regarding the ‘keystone’ to their trading success. “What is the most crucial aspect of your trading?” The majority of inexperienced traders would immediately cite “having a winning trading method” and whilst they wouldn’t be wrong in that statement it would most likely differ from the answer experienced traders would give…
The more experienced and successful traders in our group would most likely state something along the lines of; “money management, controlling risk”, or use one of the clichés in this industry that really stands up to scrutiny; “look after the downside and the upside takes care of itself”. Cutting losses and cutting them early in this business is absolutely crucial to our long term success and yet letting go of that bad trade can represent as difficult a challenge to many traders as allowing their winners to run.
So what is involved in the deep processing of our thinking that prevents us from letting go of losers easily and what measures can we put in place in order to alter what can be a very damaging practice, if not challenged and corrected?
Keeping our risk per trade down to a small percentage of our account by way of using stops is one method we could use to control risk. As a by-product this would also ensure that the money management part of our trading plan is addressed. But there is another skill involved in placing our stop where we think out trade will become invalidated that can’t just be left to placing a stop using an arbitrary figure. We can’t just use a stop of, for example, 100 pips on a swing trade and hope for the best, we have to position size our calculation to ensure that the risk is maintained at the percentage level outlined in our trading plan, whilst the pips risked is exactly at the point where we’d decided that our trade had failed.
This is where two other aspects of our trading come into focus; our discipline and our acceptance that we have to follow price as best we can, whilst giving up on the belief that there is some predictive nature to technical analysis.
How can we develop the discipline to accept that our trade has ‘gone bad’ and simply move on?
There is no easy way of working through our intense temptation to stay with losers, believing that the direction may recover. It’s almost inevitable that many of us must suffer in our early trading careers as we don’t let go of our losers when we knew that the trades have become invalidated. And in many ways new traders have to go through that pain barrier to come out of the other side wiser and stronger. But that won’t stop us suggesting a simple way to ensure that you place your stop and kill your loser stone dead, when you know it’s gone bad.
When your high probability set up has occurred, on a manual trading set up, it’s one thing to immediately click on the buy or sell ticket, but we do get time, if we’re trading off the higher time frames in particular, to calculate where our stop should be placed. And as we’ve stressed it should be placed where we’ll determine that the trade has failed. Let’s consider using a standard daily chart as a blank canvas to explain…
For example, if we receive our signal to enter long then we could look to place our stop below the lowest point of the previous day’s candle which in many circumstances will represent the recent low. That low, will in many instances, be the turning point of sentiment and should price revert back to that level, then the probability is that the trade is invalidated.
The important issue is for traders to calculate that stop to the pip and not second guess it. Then using one of the many position sizing calculators, one which is available on the main FXCC website, we can ensure that we’re not exceeding the percentage risk set out in our plan. It couldn’t be simpler, however, despite the simplicity; there may still be the temptation to violate the rules set down in our trading plan.
This is where we have to remind ourselves that all that effort and energy we’ve expended in crafting our trading plan blueprint will be ruined if we can’t use discipline to obey the rules that we’ve designed our complete trading plan around. All that blood, sweat, years and tears will have been rendered pointless if, during the earliest signs of pressure, we cave in to an emotional decision that has no place in a real trader’s armoury.
Use stops, use position sizing and ensure that your mind overcomes your emotions. Take the loss knowing that (in doing so) you’ve stuck to the plan and that next winner will be along shorty.
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