Trading Losses: A Survival Guide

Yesterday, as I sat and looked at a sea of red on the equity screen and also watched a different market where a very public call I had made was hovering around the suggested stop-loss level, I began to contemplate losses. If you have ever traded or taken an active approach to investing, you will have seen losses before, but it is how you react to them, not their frequency, that will ultimately decide whether you are successful in financial markets.

Some part of your reaction will depend on the time horizon and objectives of the initial position. Obviously, you should react differently when a short term trade goes wrong to how you should react when you see immediate losses on a long term investment. Despite those differences, however, there is one thing that should be the same: the extent and nature of your emotional reaction. More accurately, it should be the lack of an emotional reaction. It is easy to get angry and frustrated when looking at a loss, but those emotions usually lead to bad decisions. Fortunately they can be controlled, or at least limited, by going into any trade armed with certain knowledge.

When I started to run my own positions in the foreign exchange market, I was told that I should expect about half of my trades to result in losses. If you understand and accept that basic premise then you can concentrate on what really counts: staying alive to make money over the long run. The basic principle is simple. You can still make money if you get 50% of trades wrong, so long as you make more on the winners than you lose on the losers. That is why setting parameters when initiating a trade is so important, but it also limits your emotional reaction to losses when you know they are coming. For traders with a short term view in particular, this is important.

You have to view trading as a process and never, to use a well-worn cliché, put all of your eggs in one basket. While we’re using clichés, successful trading is about hitting a series of singles and doubles, not looking for home runs. Personally, I would never use more than around 20% of my trading capital for a single trade. In addition to that, a logical stop loss to limit potential losses should be set at around 20%. Thus you are never going to lose more than 4% of your capital on any one trade. The greatest mistake that new traders make is to risk everything and then refuse to cut for a loss until the damage is too great to come back from. They effectively wipe themselves out on one trade.

Avoid that by accepting that there will be losses and owning them when they come. When you do that, you will undoubtedly sometimes cut yourself out at the bottom, but that will be more than made up for by the times when your cut is a good one. Hanging around in London pubs frequented by forex guys I heard far more pride in cuts for small losses that avoided disaster than I did in winning deals. Making profit was expected; it was managing losses that kept us in a job.

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