source: here
There are quite a few books written on how to make money
in the market. Some of them are even written by people who have made money as
traders! What you don't see often, however, are books or articles written on
how to lose money.
“Cut your losers and let your winners run” is commonsensical
advice, but how do you determine when a position is a loser? Interestingly,
most traders I have seen don't formulate an answer to this question when they
put on a position. They focus on the entry, but then don't have a clear sense
of exit—especially if that exit is going to put them into the red.
One of the real culprits, I have to believe, is in the difficulty
traders have in separating the reality of a losing trade from the psychological
sense of feeling like a loser. At some level, many traders equate losing with
being a loser.
This frustrates them, depresses them, makes them anxious—in
short, it interferes with their future decision-making, because their P & L
is a blank check written against their self-esteem. Once a trader is
self-focused and not market focused, distortions in decision-making are
inevitable.
A particularly valuable section of the classic book Reminiscences of a Stock
Operator describes Livermore 's approach to buying stock. He would sell a
quantity and see how the stock responded. Then he would do that again and
again, testing the underlying demand for the issue. When his sales could not
push the market down, then he would move aggressively to the buy side and make
his money.
What I loved about this methodology is that Livermore's losses were part of a
grander plan. He wasn't just losing money; he was paying for information. If my
maximum position size is ten contracts in the ES and I buy the highs of a range
with a one-lot, expecting a breakout, I am testing the waters.
While I am not
potentially moving the market in the way that Livermore might have, I still
have begun a test of my breakout hypothesis. I then watch carefully. How are
the other averages behaving at the top ends of their range? How is the market
absorbing the activity of sellers? Like any good scientist, I am gathering data
to determine whether or not my hypothesis is supported.
Suppose the breakout does not materialize and the initial move above the range
falls back into the range on some increased selling pressure. I take the loss
on my one-lot, but then what happens from there?
The unsuccessful trader will respond with frustration: “Why do I always get
caught buying the highs? I can't believe “they” ran the market against me! This
market is impossible to trade.” Because of that frustration—and the associated
self-focus—the unsuccessful trader does not take any information away from that
trade.
In the Livermore mode, however, the successful trader will see the losing
one-lot as part of a greater plan. Had the market broken nicely to the upside,
he would have scaled into the long trade and likely made money. If the one-lot
was a loser, he paid for the information that this is, at the very least, a
range-bound market, and he might try to find a spot to reverse and go short in
order to capitalize on a return to the bottom end of that range.
Look at it this way: If you put on a high probability trade and the trade fails
to make you money, you have just paid for an important piece of information:
The market is not behaving as it normally, historically does.
If a robust piece
of economic news that normally sends the dollar screaming higher fails to budge
the currency and thwarts your purchase, you have just acquired a useful bit of
information: There is an underlying lack of demand for dollars. That
information might hold far more profit potential than the money lost in the
initial trade.
I recently received a copy of an article from Futures Magazine on the retired
trader Everett Klipp, who was dubbed the “Babe Ruth of the CBOT”. Klipp
distinguished himself not only by his fifty-year track record of trading
success on the floor, but also by his mentorship of over 100 traders. Speaking
of his system of short-term trading, Klipp observed,
“You have to love to lose
money and hate to make money to be successful…It's against human nature what I
teach and practice. You have to overcome your humanness.”
Klipp's system was quick to take profits (hence the idea of hating to make
money), but even quicker to take losses (loving to lose money). Instead of
viewing losses as a threat, Klipp treated them as an essential part of trading.
Taking a small loss reinforces a trader's sense of discipline and control, he
believed. Losses are not failures.
So here's a question I propose to all those who enter a high-probability trade:
“What will tell me that my trade is wrong, and how could I use that information
to subsequently profit?” If you're trading well, there are no losing trades:
only trades that make money and trades that give you the information to make
money later.
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