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How to Take a Loss
By Brett N. Steenbarger, Ph.D.
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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Brett N. Steenbarger, Ph.D. is a clinical
psychologist and active trader, writer, and
researcher for the past 20 years, Brett is the
author of The Psychology of Trading (Wiley;
2003) and numerous articles on trading psychology
for print and online financial publications.
Click here for full
bio >>
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