Letting your winning trade run and reduce your trading losses is a trading rule we have all heard.
The idea is to allow profitable trades to continue to grow in order to do as much as the market is willing to give.
By cutting your losses, you are looking to get out of position and save your capital when you identify that your loss trade is not preparing to go for profit. In essence, trade will not work.
It’s a clear trading rule and one you would think would be easy to follow, but for some reason traders do the opposite when they have an open position. Traders will cut their profits and small bank profits while letting the loser keep running hoping for a jump.
Why Do Traders Not Leave Winning Trades?
Laurie Santos, professor of psychology at Yale, illustrates this brilliant phenomenon in Ted Talk about the ape economy.
Here is a summary from the New York Times: When accustomed to using money, a group of cappuccino monkeys responded quite rationally to simple stimuli; unreasonably responded to dangerous games; failed to save; stole when they could; used money for food and, occasionally, sex. In other words, they behaved a bit like the creatures most of Chen’s most traditional colleagues study: Homo sapiens.
Santos adds this to Yale Economic Review: “when you see your stocks going down in red, when you see your house price going down, you will not be able to see it in anything other than the old evolutionary terms.”
When this is accompanied by high levels of uncertainty and uncertainty that we experience when trading any market or trading style, you can see that it is easy to convince ourselves that we must secure a profit or that a big loser return.
Markets are full of information and it is not difficult to create signals that support our positions (and empty those that are contradictory) when in fact there is none.
We all suffer from confirmation bias in one form or another:
For many people, being the right attribute of being objective and making money and we often see traders give up on a business plan and “lend a hand”
For some, the rules of the trade are difficult to follow
Day trading manages this risk in more cases than volatile trading due to traders having more configurations and trading signals to fight. If you are a day trader, you need to be extremely vigilant to ensure that your trading plan is something you adhere to – win or lose.
It may seem that we are adamant about doing exactly the wrong thing that will only make finding the success of the trade – which is already difficult – practically impossible.
Other traders can hurt you
Other traders can look at things similar to us and act on the same information in a competitive way. This can make getting a loss much harder, especially if you hesitate at all.
Seeing a simple but common example: if the market has reached a level where if it breaks it, a cascade of orders pours into the market, a lost exit could mean a much worse price if / when you decide to close your position.
This in turn feeds the first point and a trader can hold a trade in the hope that it will “return”. If it bounces back and rewards you with profits, you will never learn that cutting your losses is the best way to go – and it can lead you to trading habits that will eventually destroy you.
Trust in trade – ruined
If we look at some trade statistics, you will see why – yours trade statistics can be destroyed with only a small fraction of trade losses or driven by the tightening of a few extra shoes from any trade or hitting a weird house.
Let’s say that for the reasons already discussed:
In 2 trades in the set of 30, you explode
You get a loss of 6 points
A loss of 12 points – a total of 14 extra loss points
All other trades are taken as normal
Your average trade now drops to just 0.53 points per trade – due to only two trades! And this is a rather conservative scenario of what can happen when traders do not stop.
Let’s say now that in 2 trades you get 3 extra points). So this is 2 x 3 to add to the total. Your average now jumps to 1.2 points per trade – an improved figure.
Confidence and emotional balance can be broken when you lose more than you know and should be galvanized to get substantial winners. Emotional strength is a consumable resource that is invoked when things are not going particularly well – so it needs to be built and nurtured to make sure you do not lose control.
Over time, having the emotional strength and willingness to continue with your trading plan will help you avoid the big losses and trade shocks that go with these.
Let the winners run and the losers wait
The trading rule of the day “Run your winning trade and cut your losers” is a very simple rule. But it is far from the right to live in practice. Understanding the absolute importance of the rule is the first step to fully embracing it.
The next step is to make sure your trading plan is not vague to stop and gives you little room to run winners.
So how do you let the winners run?
There are several methods to let the winners run:
Scaling to reduce risk can make winners run a little easier
Reduce the risk when the price moves towards a certain profit target, such a risk multiple or significant levels of support or resistance
Hold the position until a technical indicator signal, such as a moving average junction, tells you to exit.
The hard part is having the discipline to actually hold the position while fighting the desire to realize paper profits. But holding on when the desire to come out that is not based on market reality is where the big winners come from.
Losers need an exit strategy just like profitable trades.
The hard part about cutting a losing trade is the hope that the trade will bounce back in your direction. Let’s ignore the small moves against your position when you first start. It is virtually impossible to choose the correct point of return, so we should expect any unfavorable price movements.
When it comes to adverse price movements, it comes in different flavors.
Low momentum moves against your position, considering it is not a slow move against your position, they are the ones that most would depend on.
But when momentum treads against you, you need to be close to hitting the exits. Forget hoping the trade will return as momentum can lead, and often does, to one more move before the price resumes back in the direction of the trend.
Have an Exit Plan
The key point in both losing trade cuts and making profits is to you actually have an exit plan for every position you take.
You can do something as simple as scaling the partial position to 1R and move the stop to the draw. When the price continues to move in your favor, use volatility points or a moving average to see even more gains.
While taking the time to try out which method of winning leads best suits your style, a consistent method of letting this trading rule be part of your trade is most important.
Find something – and stick with it