Superior Trading Skills through Education

Why do we do it.... Print
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Why do we do it,

letting small losses become big ones?

Warren Buffet was known to answer the question: What are the most important trading rules?

His standard answer was: Rule one - don't lose money. Rule two: Never forget rule one.

It's all in the interpretation. Did he mean 'Don't lose money on trades' which some may translate as

(A); 'I may have a losing trade on but I'll hold it because it may bounce back into profit and then I've followed rule one'.

Or, (B) perhaps it was just an off the cuff quip, meaning that to survive as a trader or investor we need to make more overall then we lose?

Letting winners run and cut losses short

This is the self evident rule we need to achieve to ensure we can make profits overall. The only problem is that the

majority of traders have a habit of doing the opposite as in (A) holding on to losers in the hope they will become profitable trades! Then, when they have a profitable trade, they take the profit too soon for fear that it may evaporate.

It becomes a viscous circle of small profits and larger losses which only serve to feed whoever takes the other side of our trades.

Back in 2000, Locke and Mann published their research on open outcry pit traders. They confirmed that traders held losing trades longer than winners. Also the average position size for losing trades was larger than the winning trades. A recipe for disaster!

They found it applied to all traders, professional or not. However they were able to identify that  "Relatively successful traders are less prone to sit on losing trades" and prove the rule of letting winners run and cutting losers quickly.

That's all simple enough. But, it's extremely difficult for traders to realise the problem exists and reverse that behaviour. The professional traders interviewed had some great stories to back up why they held onto losers such as; "I've had big loses but you're ignoring my big winners".

The facts though revealed the real story. " Comparing gains to losses...traders as a group held losses significantly longer than gains.....35% to 133% longer than holding times for gains"

Why do we do it

It's not our fault! It's the fault of our early ancestors that has become programmed into our automatic reactions! Stone age man saw a loss as a threat and would take a gamble to avoid the loss. Imagine a hard-fought battle with a ferocious animal that might become a meal for his family - or his almost certain death.

For modern mankind it's all to do with hope and fear. We tend to crave lots of quick satisfactions which drive us to grab profits as soon as they are presented for fear those profits will disappear before we have time to take them.

Hope kicks in when losses appear. We are naturally optimistic for the future and so we hope and expect and will fight for that losing trade to turn around and avoid the psychological pain of having to confront ourselves and admit we were wrong!

The solution...

Do the opposite of what our ancestors would have done! Once we have worked out that the market will do what it will, despite what we would like it to, we are making progress. Next is an acceptance that a (sizable) number of our trades will lose money. Then, take steps to reduce the losses.

It may well take some while to tease out a solid 'system' that produces profitable trades more often than not, but winning trades are less of a problem than the losing ones.

As Jesse Livermore observed "The real money is made in commitments showing a profit right from the start".

The corollary to this is that those trades that make a loss right from the start are highly likely to make a bigger loss. Mark Spitznagel, the billionaire hedge fund manager learnt the lesson early from his mentor Everett Klipp as he recounts here.

Take a loss as soon as you have it, don't wait for it to grow!


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