As humans, we have certain inherent emotional characteristics. The most common is Fear. When we’re put in a situation in which harm may come to us, fear is what triggers us to recoil or seek a safe harbor. It’s almost instinctual that we avoid situations that might cause us pain. This can be either physical (breaking a bone) or emotional pain (trading losses), as they are both experiences we will try to avoid at all costs.
Conversely, we’re attracted (like moths to a bright light) to experiences that give us pleasure. Whether it’s great food, fabulous wine or lengthy vacations to beautiful destinations, to each there own; we desire as much of these as possible. In fact, marketing agencies make millions of dollars (as do Presidential campaigns) by tapping into these emotions of pain, fear and pleasure.
It’s also true, for the most part, that when people are faced with the choice of avoiding pain versus feeling pleasure, they opt clearly for the avoidance of pain. A clear illustration of this concept applied to trading or investing is one I often use in class. I pose a scenario in which an investor owns three stocks: one is profitable, the second is break-even and the last one is trading at a loss. I then ask, “If given the choice to sell one of the three, which one would you sell first?” Invariably, most choose to sell the winner and keep the loser.
Putting off trading losses is an issue that plagues many new traders. To address this issue, let me start by sharing some observations of over 20 years in the trading world. Most people new to trading come by way of marketing campaigns. These marketers naturally appeal to people’s greed (pleasure) – usually glossing over the potential for loss (pain). The irony of course, is that to be successful in trading we must first embrace risk. Translation: we must accept trading losses and reconcile the fact that we will be wrong sometimes.
It’s well known in the trading community that doctors and lawyers make the worst traders because of their inability to accept when they’re wrong. This attribute is great for their respective professions; after all, I want a lawyer working on my behalf or a doctor diagnosing me to possess this “must get it right” type attitude. However, big egos have no place in the trading world. Ego impairs our judgment; it causes us to impose our will on the market, allowing what should have been small trading losses to expand into large losses until the pain becomes unbearable. It’s at this point that the suffering must be arrested; and the only way to do this is by closing out the position. Invariably, this happens just as the market bottoms.
What I show students in class (in an effort to de-emphasize this notion that one has to have a high win-loss ratio in order to make money) is that they should spend most of their time looking for low risk entries. The most important focal point of any trader should be to identify price levels at which he/she can expose the least amount of capital and, if proven correct, reap the most profits. What this does is re-enforces the trading maxim “cut your losses short and let your winners run”.
I find many new traders are content taking small profits, mainly because it FEELS GOOD to do so. However, if you only gain $1.00 for every $1.00 risked, you would have to have a higher than 80% win-to-loss ratio in order to be consistently profitable. This is a tall order for most professionals, let alone a novice. After commissions, taxes and trading expenses the math just doesn’t add up. On the other hand, if you profited 3 to 5 dollars for every dollar lost, you see that even if you’re right only 50% of the time you would still be profitable overall. Incidentally, some of the most profitable (audited) methodologies have about a 40% win-to-loss ratio.
The way to calculate risk-to-reward ratios is quite simple. Say you’re trading the ES (E-Mini S&P) with an 8-tick stop loss ($100). If you’re buying it at a demand level, you should figure your first target would be the next fresh opposing supply level. That supply should be a minimum of 24-ticks ($300) away, if this is not the case, you should consider passing on that trade and wait for a better set-up.
All and all, if you have a proven low risk strategy, and aren’t bothered by taking small losses, and have the mental fortitude to let your winners hit their targets, you can move towards experiencing the pleasure of being a consistently profitable trader.
Until next time, I hope everyone has a profitable week.