For most traders, there’s nothing more frustrating than experiencing a trading loss. As a result of this, some traders will procrastinate booking a loss until the pain of the loss become so great that they have no choice but to do so. We will go over some of the reasons why cutting your losses in the market is so difficult to do, and provide some tips to help you manage your losses better.
What Does It Mean To Cut Losses Quickly?
One of the most popular axioms within the market is the following – Let your winners run and cut your losers short. If you’ve been around the market for any length of time, you have surely heard this axiom. But what does it actually mean to cut your losses short? Well, cutting your trading losses short means that you should close out a relatively small losing position before it has a chance to turn into a big, unexpected loss. It’s as simple as that. But, although it’s relatively simple to understand in theory, it can be extremely difficult to implement at times.
The reason that cutting a losing position quickly is paramount, is because it is a critical component to protecting your trading account. And so, if you do not have a solid risk management plan that includes within it how you will be managing your losing positions, and when it’s time to throw in the towel, you can run into a situation that may compromise your trading account. The sooner that you realize this as a trader, the better off you will be in the long run.
Most successful traders seek out asymmetrical reward to risk trading opportunities. That is to say that they are looking for set ups that provide them with many more units of reward per unit of risk. More specifically, that may translate into reward to risk ratio of 2 to 1, 3 to 1, or higher. As such, these more experienced traders in the market have come to realize that losing trades are just the cost of doing business. It’s a necessary business expense that must be incurred in order to achieve their expected edge over a long series of trades.
Many amateurs traders on the other hand have a difficult time with cutting their losses short. There are many psychological reasons for this, which will be getting into soon. But, for now, you must have a clear understanding of what it actually means to cut a loser short. And again, that is to say that you must have some mechanism in place to close out a losing position before it can balloon to a point where it becomes lopsided from the reward to risk profile or in a worst-case scenario, becomes completely unmanageable.
Reasons Why Traders Delay Cutting Losses
There are a host of reasons why traders find it difficult to cut their losses even when they know innately that it is the right thing to do in a given situation. This shortcoming often stems from psychological factors and our social environment that ingrains within us certain ideas about right and wrong. Let’s take a look at some of the major factors that prevent traders from taking a loss on a trading position.
Do The Right Thing – From an early age, we have been taught to do the right thing, and avoid doing the wrong thing. Most of what we know to be right and wrong is instilled within us by the time we are in elementary school. As we move into our teenage years, and early adulthood, we strive to do the right thing so that we can fit within societal norms. We are told to study hard, get good grades, get a college degree, find a suitable job, get married, and have two and a half kids, and so on and so on.
Now, if we decide to enter into the trading arena, a lot of what we have learned through the years will be counter to what it takes to become successful in the markets. More specifically, when it comes to trading, we will often be wrong more times than we will be right. This characteristic is difficult for many people adjust to. As such, they will tend to do whatever it takes to avoid being proved wrong in the market. This in turn can lead to holding onto losing positions for much longer than they should.
Hoping Things Turn Around – If asked, is the glass half-full or half-empty, those that answer that the glass is half-full are often recognized as positive outlook type individuals. On the other hand, those that answer that the glass is half-empty are often categorized as negative outlook type individuals. In society, hope and optimism are more admirable traits than fear and pessimism. What does this have to do with cutting losses, you might ask? Well, again, everything that we do in the market comes from our personal beliefs and interactions in society.
And so in this case, hope rains eternal in the eyes of a trader holding a losing position. Isn’t it better to stay positive and optimistic and hope that a losing position turns around? Isn’t that what we might do in most other social settings outside of the markets? This again, is completely counterproductive to our efforts in the markets.
That is to say, in the markets, hope is not a strategy, and it will more likely lead us to the poor house. In the markets, it’s usually those individuals that have a near obsession with risk and loss that are more likely to survive and thrive for the long-term.
Brain Is Wired To Avoid Losses – Even biologically, it’s difficult for us to hold onto a losing position. Human beings are wired in such a way that we have a huge propensity for loss aversion. This loss aversion has been studied and validated by behavioral psychologists. Prospect theory has shown that people generally make decisions based on their potential perception of losses and gains rather than rational probabilities.
Furthermore, individuals have a much stronger tendency to avoid losses compared to realizing gains. This plays out in the financial markets, as traders holding a losing position avoid booking a loss at all costs because it’s inherently uncomfortable to do so. Essentially, the pain of a loss is many times more impactful than the joy of a gain.
Averaging Down Mentality – Then there is the averaging down mindset. Some traders who may have less susceptibility to psychological shortcomings of taking a loss on a trade, may still suffer from the average down mentality. That is to say that these traders have a strong belief in Martingale type money management strategies.
Generally, Martingale betting strategies rely on continually adding to losing positions. Traders that implement these strategies are typically contrarian traders utilizing mean reversion approaches. The problem with this model is that the markets can remain irrational for long periods of time, and can sometimes wipe out a traders account.
Adverse Effects Of Not Minimizing Trading Losses
Now that we understand some of the psychological aspects that lead us to hold losing positions rather than liquidate them quickly, let’s now discuss the mathematics of trade losses. Let’s start with a relatively easy example.
Assume that you purchase $1000 worth of stock at $20 and that stock moves down by 20%. In this case, the stock would then be worth $16. Now in order to get back to breakeven, that is for the stock to move from $16 to $20, that will require a gain of 25%. And so, as this stock example illustrates, if we lose 20% on any trading or investment position, then it will require a gain of 25% to get back to breakeven.
What about a somewhat larger loss? Well, let’s illustrate with another example. Let’s assume you purchase $1000 worth of stock at the same $20 per our earlier example, and the stock moves down by 33% in this case. Well then, the stock would be worth $13.40. Now in order to get back to breakeven, that is for the stock to move from $13.40 back to $20 to realize breakeven, that would require a gain of 50%. And so, if we lose 33% on any trading or investment position, then it will require a gain of 50% to get back to breakeven.
These two examples should help you to understand the asymmetrical nature of losses. And this asymmetrical nature becomes exponential, as the losses accrue in magnitude. Let’s take some extreme examples to illustrate the nature of asymmetrical losses.
If your portfolio loses 80% of its value, then you will require a 400% gain to get back to breakeven. And if you portfolio loses 90% of its value, then you will require a 900% gain to get back to breakeven. What about if you lose 99% of your portfolio? Care to guess how much return you will need to get back to breakeven? You will need a mind-boggling 9900% return to get back to breakeven in that scenario.
So it’s clear that curtailing trading losses is an essential component to a traders long-term longevity. Sooner or later, if you do not practice strict risk minimization rules on your trades, you will have a losing trade or series of losing trades that will result in making it virtually impossible for you to recover from. This is not a matter of conjecture. It is a mathematical fact.
When To Cut A Losing Trade
As you should now have a better appreciation for cutting losses, let’s move on to outlining some basic rules and guidelines for knowing when it’s time to actually go ahead close out a losing position and cut your losses.
Original Edge No Longer Exists – One of the best ways to ensure that a losing trade is closed out effectively is to place a hard stop in the market at the moment that you initiate a trade. When you’ve done your market analysis, you should have a pretty good idea as to what your edge in the trade is and the invalidation point which would no longer favor remaining in the trade.
Some traders have a hard time placing hard stops in the market, but in fact, it is one of the simplest and most effective ways to control your downside risk. If you get into the practice of doing this, you will save yourself a lot of aggravation and emotional toll, because you will have learned to let the market take you out of your position automatically, at a predefined level based on your original market analysis.
Strong Attachment To A Trade – There are some trades that go in our favor from the very outset. Others do just the opposite, and begin to move contrary to our position following our entry execution. Sometimes, when trades move contrary to our intended bias, we begin to feel an attachment to the trade. This may be because we have a strong feeling about a particular market analysis.
Even if at some point we are proven correct in our assessment, it never pays to fight the market. As such, any time you feel a strong attachment to a trade and that trade is moving against you, you need to throw in the towel to ensure you’re protecting your trading account.
Contrary Weight Of Evidence Stacking Up – One common phenomenon that traders face after they have committed to a position in the market, is one of closed mindedness. That is to say that we will be the most objective just prior to initiating a trade. Once we are in the market, either long or short, our mind will tend to focus on those things that favor our market position, and try to negate or minimize those things that favor the contrary position.
This is something that traders need to be aware of and work on constantly. You should put in certain routines or procedures to ensure that you are forcing yourself to remain as unbiased as possible, and that you are objectively evaluating evidence that may be stacking up against your current position. And by doing so, you will be better able to manage a losing position.
Techniques For Cutting Trading Losses
So what are some tips for cutting a losing trade? Well below you will find a list of tips that will help you better manage your losing trades, and cut your losses quickly before they get out of hand.
Use An Initial Stop Loss – As we noted a bit earlier, one of the most effective ways to cut a trading loss quickly is by using an initial stop loss. Most trading platforms these days allow you to use bracket orders. Bracket orders trigger both a stop loss and a take profit level upon entry execution.
By getting into the habit of using bracket orders you will be building discipline automatically into your trading. Much of the mental dilemmas associated with managing your losers will be removed. Although some traders may not feel comfortable with this type of set it and forget trade management process, it does have its benefits. And those benefits outweigh the downsides by a mile.
Use A Trailing Stop Loss – In addition to utilizing an initial stop loss to quickly cut a losing trade, you can also incorporate trailing stop loss mechanisms. A trailing stop loss will move in the direction of your trade as the price moves in your favor. Both discretionary traders and systems traders can take advantage of trailing stop loss orders.
Discretionary traders will generally watch the market and adjust the trailing stop losses manually. System traders can have trailing stop loss mechanisms programmed into their mechanical system. One popular trailing stop technique is the Chandelier ATR trailing stop loss.
Use A Time Stop – Most traders only think of trading in one dimension. That is to say they focus on the price axis, and never pay much attention to the time axis. Time is an important component within the markets, and traders who understand this can take advantage of it in their trading.
One way to use the time component is to have some rule in place that will take you out of the trade after a specified number of candles or bars. You should do the necessary research into your trading system or strategy to evaluate the time metrics within your strategy.
For example, you should know what the average time in trade is for your winning trades, and the average time in trade is for your losing trades. Armed with this information, you can build a time stop mechanism wherein your trade would be closed out after a specified amount of time has elapsed. This will help in giving you clear instructions on when it’s time to close out a position, and can be particularly helpful when that position is in losing territory.
It’s never fun when you are experiencing a losing trade. Having said that, losing trades are inevitable in the game of market speculation. The sooner that you realize this, the faster you can overcome the anxieties and negatively charged emotions that accompany trading losses. It’s only when you have gained the ability to cut a losing position objectively and without emotion, that you can truly excel in your speculative activities in the market.
When cutting losses in forex or any other market, one simple exercise can go a long way. More specifically, try to think of losses in the market as expenses in your trading business, and gains in the market as revenue in your trading business. This way you will begin to detach yourself from the results of each individual trade.