Sunday, September 20, 2009

Loss aversion

Being willing to take a loss is key to being a successful trader.

Why? Because no matter how detailed your analysis you can't nail it every time. There are often going to be things you miss. In fact, I've heard numbers that suggest that those with a high win/loss ratio (more winning trades than losing ones) actually make less money than when the reverse is true. The reason is that those latter traders are willing to take many small losses but when the profits start they don't close out the trade too quickly. The ones with the high win/loss ratio are taking smaller profits aren't generating the dollars in profits to more than slightly offset their losses.

Unfortunately, many traders hate losses. Hersh Shefrin wrote in his book, Beyond Greed and Fear, that a loss has 2 1/2 times the impact on a person than a win does. It's not the loss itself but the feelings that accompany the loss. The sense of being responsible for the loss causes pain. Self esteem issues come into play. These feelings, powerful and negative, affect decision making. The result? Traders let losses continue to run or sometimes don't get in on traders because of the fear of loss.

You can't trade without losses. Period. When you have a loss the market is actually giving you some valuable information. Getting to the point where you can accept that information is the challenge. I've pointed out before the need to reverse on information (not always but sometimes).

How do you minimize the losses? Certainly by keeping stops small. How do you keep stops small? By carefully finding your entry points. How do you do find the entry points? Ah, that's the big question and traders have different approaches.

Support and resistance is one way. That's what caused me to buy the GBP/JPY earlier last week taking a nice profit and then selling it in the latter part of the week, a trade I'm still in where I've already locked in profit. It can work and it's so very very simple. Anyone can do it. But it doesn't always work. Especially after three or four times of reaching a level, the pair can get through. When it does, it takes out your stop. That's when you have a loss. Those are the losses you have to be willing to take.

What if you have a series of losses? Even small losses, repeated frequently enough, can erode a trader's self confidence to say nothing of his or her capital. I've had, and still sometimes have, times like this. Sometimes it's just because you're radically out of step with the market. For example, you're a trend trader and the market starts going sideways. Or you're an S&R (support and resistance) trader and the market starts trending. Or it's because the stars are wrong. (Don't laugh--some traders, not all of them unsuccessful, take the movement of planets into account). But mostly, as Shakespeare wrote, the fault lies not in the stars but in ourselves.

You can take a cooling off period. Re-evaluate your approach. Re-do your analysis. But when this is done and you get back into the market, you're still going to have to take losses in order to be successful.

"Success is the ability to go from one failure to another with no loss of enthusiasm," Winston Churchill said. That is true for traders, but only if you keep your failures (losses) small.

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