Learn How to Lose to Win Over Time

‘If you’re in a hole, stop digging.’

Traders do not begin trading because they expect to lose. Nevertheless, losses are the rule rather than the exception for new traders. Every successful spread trader first had to learn how to lose before he learned how to win.

Traders who fear losses do not fear the market; they fear themselves. They do not yet trust their own ability to limit losses. Once a trader trusts that he will always act in a way to protect himself from large losses, he will no longer trade with fear.

Trading is managing risk, and cutting losses short is the first imperative of risk management. The ability to take, and then forget, a small loss frees the trader emotionally and financially for the next trade. The good trader cultivates a bad memory.

Experienced traders are able to back away easily from losing positions because they are confident that they can always get back in. It is not unusual for a trader to take a number of small losses before a position begins to work in his favor.

Losses are an ordinary cost of doing business. Accept them quickly and gracefully. Above all, do not let losses tempt you to anger or frustration. Your goal is profit, not perfection. The last trade, like the last golf shot, is history. Address a bad lie with your best shot.

The Best Defense: Proper Trade Entry

Taking a loss properly begins with trade entry. One advantage of entering trades as closely as possible to critical short-term support or resistance is that a bad trade is quickly identified. If the trade is entered when the stock is at a low-risk entry point, then the trader should expect that the price will not move against him by much, if at all. Maintaining a close tolerance upon entry provides the trader with good reason to exit the trade quickly should price break protective support or resistance.

It is not always necessary to wait for a loss before aborting a trade. Sometimes price will move in the desired direction, or not at all, but the price-volume activity suggests that adverse forces are gaining control. Get out of a trade if it fails to come up to expectations or if price-volume indications turn negative. If the tape says, “Get out!”, do not argue.

Because markets are the free and spontaneous creation of buyers and sellers, surprise is commonplace. Rely on your continuing judgement of the unfolding tape. Remain nimble and prepared to change your mind in a moment, for you cannot change the market.

Establish a perimeter around each trade you enter–limits beyond which you are no longer willing to keep the position. These limits should include time as well as price. If a trade takes much longer to unfold than you anticipated, this may be an indication that the trade is not ready to be taken.

How to Use Stops

Beginning traders should always use stops. Experienced traders who trade large positions may choose not to use stops, because they do not wish to become the target of other traders gunning for stopped shares. Instead, these traders employ mental stops by setting a time-price perimeter and watching their positions closely.

Stops should not be used routinely to exit positions, but should be placed in order to safeguard against the unexpected. Stops are a form of accident insurance. We all have insurance, but all of us hope never to benefit from it. The alert trader will cut back or eliminate endangered positions before stops are reached.

Stops should be placed outside the price limits you have set for your trade. You should use your own judgement to reduce or exit a position within the perimeter you have set. Your stop should be triggered only in the unlikely event that your perimeter is breached before you are able to act. If you expect to be away from the market for any significant period, use stops.

If you are trading online, you may experience a communications failure at any time. In the event of a sudden sharp move in the market, your broker may be swamped and unavailable either by phone or online. To protect yourself against these possibilities, use stops.

Most traders set stops at whole numbers. If, for example, there is near-term support for a stock at 55, then one might expect a cluster of sell stops at 54, and again at 53, and so on. Traders gun for these stops in order to scoop up cheap shares. If support is broken, then one might expect the stock to trade down to an even number before support is asserted. For this reason, it makes sense to set your own stop beyond whole-numbered prices. Instead of 54 on a sell-stop, set your stop at 53 7/8 or 53 3/4.

After whole numbers, these fractions attract the most stops, in descending order: halves, quarters, eights. In most cases, it’s a good idea to set your stop at some multiple of eights beyond the nearest whole number.

Averaging Down

Most beginning traders make the mistake of increasing their position when a trade has moved against them. Their logic is this: averaging in lower cost shares with higher cost shares lowers overall cost per share. As a matter of pure arithmetic, that is correct. As a matter of practice, it is lethal.

If there is one mistake that will sooner or later destroy a trader, it is averaging down. NEVER, EVER, AVERAGE DOWN. The first article of successful trading is this: reduce losing positions and add to winning positions. Averaging down runs directly counter to this imperative. By extension, the inverse is true of short positions: never average up a losing short position.

Gambler’s Trap

Keep a daily log of account equity. What is most important to the trader is the trend of profits, not the trend of prices. Add to trading capital when you are winning, cut back when you are falling behind.

Even experienced traders sometimes make the mistake of increasing the size or frequency of trading in an attempt to make up for losing trades. This is the gambler’s trap. Addicted gamblers hope to get even by digging their way out of a hole. If this becomes your pattern of response to losses, stop trading (and get help).

Loss of Nerve

A quite different, but equally destructive response to a series of losses, is to stop trading out of fear. Even more serious than loss of capital is loss of nerve. Trading is the business of the trader. If the trader cannot trade, he is out of business. After a string of loses, continue to trade, but trade small until your equity begins to rise again. As your trading results improve, increase trading size slowly until you are back on a winning track.

If you are committed to becoming a consistently successful trader, then every loss is a lesson. A loss is not a loss if you have learned something important.

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