As almost every trader knows, cutting losses is a critically
important component of successful trading. The key, of course, is to
know how and when to cut those losses. Unfortunately, all too often,
emotions play a significant role in when we cut our losses. Taking
the loss is a decidedly unpleasant experience because it implies that
we are admitting a mistake and most of us aren't crazy about admitting
that we made a mistake.
I believe it is a useful exercise to keep track of how long we
remain in losing trades and compare that to how long we are in the
winning trades. My guess is that many less successful traders tend to
remain in the losing trades longer than in the winning trades. A
number of factors may influence that tendency. Among them are the
unwillingness to admit we were wrong and the "hope" that "it'll come
back." When I review my own trading at times when I think I am not
doing as well as I should, I find that I may have stayed longer in the
losers than in the winners and that is even with careful awareness of
the need for absolute discipline. Once I identify the problem, I am
usually able to correct it by returning to faithful adherence to my
personal business plan and assuring that I adhere to my disciplined
and pre-determined exits when positions go against me.
Dr. Ari Kiev, in his 1998 book, "Trading to Win" notes another
even more insidious characteristic of hanging onto losers. "...[M]any
traders," Dr. Kiev says, "believe, at least unconsciously, that loss
is less painful when there is an addition to a larger loss than when
it is a freestanding loss." In other words, traders tend to let the
loss compound once the initial loss is in place. We really do need to
pay attention to our losers and do something about them.
All of that deals with some of the psychological aspects of how
traders may tend to deal with risk of loss and actual losses once a
trade is in place. Those phenomena are distinctly different, in my
view, from risk aversion. I devote much of my book,
"Trade Your Way to Wealth," to risk aversion which I consider to be ways to set up
trades even before we enter them to limit losses substantially or even
remove the risk of loss in certain strategies. I believe that if we
train ourselves to enter trades with both the knowledge of the
specific risks and a method in place to limit those risks we are
giving ourselves an edge in the market overall and in the control of
our own trading psyches. In
"Trade Your Way to Wealth," I discuss the
specific risks attendant to at least 15 different strategies and show
where and how those risks can be limited or, in some cases, even
avoided.
Risk aversion, in my view, is different from loss aversion. In
the former, we can plan our trades to avoid, limit, or at least
measure the risk before we ever enter a position; in the latter case
we leave ourselves in a position of trying to avert loss only after it
has begun to occur. Whenever possible, I believe it is better to set
up all parameters of our trades before we ever enter a position. If we
do that, we have gone a long way to avoiding emotional reaction to
market movement and emotional reaction in the markets is a serious
enemy. If we are making our decisions in the heat of market movement,
emotions will almost certainly have a detrimental effect on our trading.
Good Trading!
Bill Kraft
Editor of $10 Trader, Option Trader and Trend Trader
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