Most traders focus only on winning, on making the big trade. It is much safer to think first about losing and how to manage and control losses. When you learn to ski, one of the first things your instructor will teach you is how to fall safely. Not knowing how to lose safely can result in catastrophic losses.
Bad losses create fear and then traders fail to take new attractive trades. A successful trader must learn to lose properly and learn to love taking small losses. Just like falls on ski slopes, this is a normal part of the game.
The following is a good sequence of steps:
1. Eliminate disastrous losses
2. Learn to lose properly
3. Learn when not to trade (look for higher probability trades)
4. Learn to ride winners
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Once you master items one and two, you can focus on items three and four.
To achieve long-term success you must develop techniques for setting risk limits and dealing with inevitable losses. We must learn to embrace losses so that we can win.
Disastrous losses become the undoing of many traders. The first step towards success consists of learning to avoid them. Traders continue suffering because they’re unwilling to accept a loss.
A trader needs to recognize when a trade is not behaving the way it should and what is the maximum loss one can ever take. At some point we have to accept a loss – unwillingness to do so will affect the psyche and lead to more fear, preventing us from becoming a successful trader.
I used to battle against losses, believing something was wrong with my system if I had to take a loss. I kept tweaking my system and never leaving it alone. I would take a loss one day, then trade differently the next day. I felt like a dog chasing its tail.
A conversation with one of my company managers made me realize that I needed to handle my trading the same way as my business.
A manager in my company noticed that I was upset and asked whether I was upset with him. I replied that I was irritated by trading losses that day. He thought it was strange, because I never got upset over losses on individual jobs that happen from time to time. I replied that I don’t expect us to make money on every single job and it’s a cost of doing business in this industry to incur occasional job losses. What mattered most was how we managed a group of jobs over time. I did not expect to make money each week or every month. My manager politely asked, what the difference was between that and trading.
The only difference was that in business I didn’t have five screens flashing green and red every minute of the day, showing how much I was making or losing at any given moment. I was OK knowing that I would not make money on every individual job, yet I was letting trading losses take me on an emotional roller coaster.
Think about it for a minute. Is it so terrible to take a loss on a few positions? I am sure if I had to run my business with a ticker tape in front of me, it would be just as difficult to deal with the daily ups and downs. I see my profits and losses on a monthly basis in business, but in trading I get to see them for each position minute by minute.
I had to train my mind to deal with trading losses just like with business losses. Losses are a normal cost of doing business and nothing more than a businessman’s risk. What’s important is the profitability over time and not the profitability of any one position. I needed to focus on the total result, not the individual result.
That brief conversation with a manger who was not even a trader helped me recognize that I was allowing individual losses to take up much of my focus and cause me emotional pain. I was getting more upset over a $200 trading loss than a $10,000 project loss in the company. I was running a multimillion dollar company with fewer worries or emotions than my small trading account at that time. As my manager walked out my office, I could not help but laugh at this paradox.
My mindset changed after I realized that a loss on an individual trade was no different than a business loss on an individual project. I began to manage my trading like I was managing my business. Trades were individual projects. I would lose money on some and make money on others. My primary focus shifted to the overall process rather than each individual trade. In the end what mattered was that I was making more than I was losing over a set number of trades.
Becoming a realist and accepting that some trades are not going to work helps me keep my emotions in check. I even removed trade balances from my screens in order to keep my focus on the process rather than each individual trade.
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Dr. Alexander Elder is a private trader and a teacher of traders based in New York City. He is the author of several international best-sellers, including Trading for a Living, and Come into My Trading Room. SpikeTrade.com is an international website that runs a weekly competition for the best trades in the US stock market. The winner of each weekly round writes a report “How I Won My Gold.’ For more information and a trial membership please visit www.spiketrade.com