Many people enter trading, whether it be stocks, options, commodities or other markets, after having been very successful in their primary occupation. Many of these new traders are perfectionists by nature and driven to be successful. This often leads to a couple of fatal flaws in trading:
1) The novice trader stays with a losing trade too long because of a reluctance to admit the original analysis was incorrect. His or her ego and sense of success are intertwined with the trade.
2) The novice trader does not understand that losing trades are a necessary cost of doing business.
The reality of the trading business is that some percentage of one’s trades will be losers. Every business has overhead expenses, or costs of simply opening the doors for business. Trading is no different and trading losses are a large part of those overhead expenses. Once one accepts that aspect of trading, it becomes much easier to close losing trades early with minimal emotional attachment.
It is also crucial to post audit your trading every month. I evaluate each trade that lost money and categorize it as a “losing trade” or a “bad trade”. The bad trade is the one where I did not follow my own trading system rules, whereas the losing trade was executed and managed correctly, but simply did not turn out positively – it was part of my overhead.
The precise percentages of losing trades will depend upon the markets being traded and also the particular trading strategy. For example, many successful commodity traders will only have 30-40% winning trades. At first blush, that doesn’t appear to be a viable proposition, but the key is the ratio of gains on the winning trades versus the losses on the losing trades.
For example, let’s assume my trading system’s average winning trade returns $250 but my losing trades average about $500. That doesn’t look like a winning system, but the crucial missing piece of information is the ratio of wins to losses. If I win 10 of the next 12 trades, I will gain $2,500 and lose $1,000 on the two losing trades for a net gain of $1,500. Another trading system might have a different pattern, e.g., winning trades average a $750 gain, but losing trades average losses of $100. This pattern of wins and losses is fine if the probability of success is high enough to make up for the losses. For example, if my probability of success is only 20%, this system will be profitable. Out of the next ten trades, two winners would account for $1,500 while the eight losers would total $800 in losses, for a net gain of $700.
Always understand the risk/reward ratio of your trading strategy. Couple that with the probabilities of success and loss to know the expected value of a series of trades using this system. Depending on the parameters, one system will be profitable with infrequent, but large, winning trades, while another profitable system may be characterized by highly probable, but small, winning trades.
This explains why you often hear a trading guru adamantly insist that you must always trade where the maximum gain is at least three times the maximum loss (a low risk/reward ratio). But then you hear another well known trading coach tell you that the best trading strategies are the ones with probabilities of success greater than 85%, with a high risk/reward ratio. Nether system is superior. But each system has its own pattern of wins and losses and optimal trade management. Which system is most compatible with your trading style and risk tolerance?
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