Allowing your winning trades to run and cutting your trading losses is a trading rule we’ve all heard.
The idea is to let profit making trades continue to get as much as the market is willing to give.
By cutting your losses, you are looking to exit the position and preserve your capital when you identify that your losing trade is not setting up to make a profit. In essence, trade will not work.
It’s an obvious trading rule and one you’d think would be easy to follow, but for whatever reason, traders do the opposite when they have a position open. merchants cut your profits and deposit small profits while let the loser run waiting for a bounce.
Why don’t traders allow winning trades to be executed?
Laurie Santos, a professor of psychology at Yale, beautifully illustrates this phenomenon in her Ted Talk on Monkey Economics.
This is a summary from the New York Times: When taught to use money, a group of capuchin monkeys responded quite rationally to simple incentives; responded irrationally to risky bets; failed to save; they stole when they could; they used money for food and sometimes sex. In other words, they behaved a bit like the creature that most of Chen’s more traditional colleagues study: Homo sapiens.
Santos adds this in the Yale Economic Review: “When you see your stock plunge into the red, when you see your house price go down, you won’t be able to see it in anything but old evolutionary terms.”
When this is combined with the high levels of uncertainty and ambiguity that we experience when trading in any market or in any style of trading, you can see that it is easy to convince us that we should bank some profit or that a big loser might come back.
Markets are full of information and it is not difficult to conjure signals that support our positions (and delete the contradictory ones) when in fact there aren’t any.
We all suffer from confirmation bias in one way or another:
- For many, being right trumps being objective and making money and we often see traders give up on a trading plan and “fly”.
- For some, trading rules are hard to follow
Day trading runs this risk more often than swing trading because traders have more trade setups and signals to deal with. If you are a day trader, you have to be very vigilant to make sure that your trading plan is something you stick to – win or lose.
It can seem like we are programmed to do exactly the wrong thing that will only make finding commercial success, which is already difficult, virtually impossible.
Other traders can hurt you
Other merchants may be looking at similar things to us and acting on the same information competitively. This can make taking a loss much more difficult, especially if you hesitate.
Looking at a simple but common example: if the market has reached a level where, if it breaks above it, a cascade of orders flow into the market, a missed exit could mean a much worse price if you decide to close your position.
This, in turn, feeds into the first point and a trader may well hold on to a trade in the hope that it will “come back”. If he comes back and rewards you with profits, he will never learn that cutting his losses is the best way to go, and it can lead to trading habits that will eventually destroy him.
Confidence to trade: ruined
If we look at some business statistics, you’ll see why: your business statistics can be wiped out with just a handful of losing trades or boosted by squeezing a few extra ticks out of each trade or hitting that odd home run.
Let’s say that for the reasons already mentioned:
- In 2 trades in the set of 30, explode
- You take a 6 point loss
- A loss of 12 points – an additional 14 point loss in total
- All other exchanges are taken as normal.
Your average trade is now down to just 0.53 points per trade – for only two trades! And this is a pretty conservative scenario of what can happen when traders don’t take their stops.
Now let’s say that in 2 operations you get 3 additional points). That’s 2 x 3 to add to the total. His average now jumps to 1.2 points per trade, an improved figure.
emotional balance
Confidence and emotional balance can be shattered when you lose more than you know you should, and galvanized by taking significant gains. Emotional strength is a draining resource called upon when things aren’t going particularly well, so it needs to be developed and nurtured to make sure you don’t lose control.
Over time, having the emotional strength and willpower to stick with your trading plan will help you avoid big losses and the trading shocks that come with them.
Let the winners run and the losers cut
The daily trading rule “Execute your winning trades and eliminate your losers” is very simple. But it is far from easy to live in practice. Understanding the absolute importance of the rule is the first step to fully accepting it.
The next step is make sure your trading plan is unambiguous about taking stops and gives you room to run winners.
So how do you let the winners run?
There are several methods to let the winners run:
- final stops
- Scaling out to reduce risk can make letting winners run a bit easier
- Reduce risk as price heads for a set profit target, such as multi-risk or significant support or resistance levels
- Hold the position until a technical indicator signal, such as a moving average crossover, tells you to exit
the hard part is have the discipline to fill the position while fighting the urge to take profits on paper. But holding on when the impulse to get out that is not based on the reality of the market is where the big winners come from.
Losers need an exit strategy just like profitable trades.
The difficult part of cutting a losing trade is hoping that the trade will rally in your direction. Let’s ignore the small moves against your position when you first trigger an entry. It is virtually impossible to pick the exact turning point, so we should expect some adverse price movement.
When it comes to opposite price movement, it comes in different flavors.
Low momentum moves against his position, considering it’s not a slow grind against his position, is something most would hang on to.
But when momentum works against you, you should be close to reaching the exit. Forget waiting for the trade to come back, as momentum can and often does lead to one more momentum move before price resumes in the direction of the trend.
have an exit plan
The key point in both reducing losing trades and letting profits run is actually have an exit plan for each position you take.
You can do something as simple as scale the partial position at 1R and move the stop to break even. When the price continues to move in your favor, use reversal points or a moving average to look for even more profit.
While you take the time to test which method of executing winners best suits your style, the most important thing is a consistent method to allow this trading rule to be part of your trading.
Find something and keep it
