Trading rule number 6: control your losses
One of the most important rules in trading is knowing how to control your losses and to keep pace with events. This is what generally makes the difference between a losing trader and a winning trader in the short, medium and especially long term.
Cut your trading losses or you are doomed
On my site's trading forum, almost every week you see people telling us that they have lost everything, that their account dropped to zero because they were unable to cut their losses, they waited for a turnaround in the market that could miraculously save their portfolio. This attitude reflects a form of autism where we hold onto anything which could give us a little hope, we do not look reality in the face, we behave irrationally in the true sense of the word. We cannot afford to trade hoping for this type of event, it is unsustainable in the long term. We can be saved once, twice but one day or another, we won't be so lucky. It is absolutely essential to rid yourself of ‘luck’ when trading, there is none, it doesn't have any effect, there are only positive and negative trades.
Why don't we cut our trading losses?
People give numerous reasons for their stubbornness in not wanting to cut their losses: cutting your loss is often more painful narcissistically than for your wallet. In fact, here is where psychology plays a full part: trading is perhaps the only activity where we face the consequences of our choices in real time. Trading is to constantly face a mirror which reflects what we really are, there is no escape. In psychoanalysis, personal identity consists of 3 things: the Id (simply our unconscious), the Ego / Me (what we really are at one moment in time), the Superego (the limits that society imposes on us, our education, etc.). And to add spice to this delicate balance of contradictory forces which make up our personality, you need to add the ideal Me, which is what we would like to be.
Trading reflects back at us, sometimes brutally, what we really are. With each position we test the reality of the trader that we are, we test how our ideal Self compares to our true Self. Because of this many traders will lose everything by not yielding, remaining inflexible faced with the markets because cutting their losses would be wrong and being wrong would damage their self-image, this would shatter their ideal Self, their Ego. It is for this reason that we sometimes find people who have been ruined on the financial markets and who are not going to stop telling you that they were right, that their analysis was good and that the market was either totally manipulated or that only idiots trade. It is simply a defensive reaction to protect their injured Ego, their ideal Self, blinded by reality. They do not want to look reality in the face, they avoid the mirror and so they need to find a scapegoat: the broker, the method used, the indicator, etc. which are inevitably bad.
An example of a controlled trading loss
Trade number 1 was made under the daily pivot point of the Dax 30 in anticipation of a recovery on this support. The daily support, S1 served as a second area of possible recovery to exit flat. The value of this position was in the low spread between the daily pivot point and support 1 that could indicate a wide zone of elasticity to exit with a gain or flat.
Some bad news in Ukraine was announced, which caused a loss of 60 points on the Dax, the expected recovery didn't happen, as soon as S1 broke, the loss was taken, that is - 22 points per lot. The scenario didn't happen as expected, we got out to take advantage of new opportunities.
If we had not taken this 22 point loss, it would have been - 82 points at the morning peak and -183 points at the end of the session, we would then have moved into "hope" mode in both situations.
By exiting, by accepting our losses, we were able to reposition ourselves on S2, we could operate on the market again and made a gain of 68 points per lot. Accepting a 22 point loss thus enabled us get out of a delicate situation and reposition ourselves on a new opportunity chart. The balance is plus 46 points but above all the trader's working capital was not threatened by the "hope" mode that annihilates many traders every day. Taking losses is also a positive act in trading, it enables us to remain dynamic and not to miss a new opportunity because our capital is tied up in "hope" mode.
How to accept taking our trading losses
As we have seen, the psychological aspect is at the centre of being able to accept taking trading losses. There is no mystery, you have to work on yourself, on losses (symbolic and real). For this, psychoanalysis or psychotherapy can be of great help in identifying the reasons behind this narcissistic weakness. Beyond trading, this also opens up opportunities for daring to do things. A lot of people are inhibited, fear of failure, of discovering that they will never be able to achieve their ideal Self, makes them not act. French society does not value failure, it condemns it even though in the United States of America, for example, a person who has experienced many failures is valued, he is a veteran, he has had the courage to try, and his status is raised.
It should therefore be acknowledged, that for a person it is often part of the accomplishment, to lose, to be wrong. I have rarely met people who are capable of saying: I was wrong, usually the prevailing opinion is: I was right, the others were wrong. A person who can live off his trading is statistically exceptional they are among only 5% of traders. They have accepted the reality that they are not perfect, they never will be, they will still be wrong hundreds, maybe thousands of times…and that is of absolutely no importance. You must be totally uninhibited with regards to failure and when it arises, to accepting trading losses. Doing this makes your management and abiding by your stops much easier. Far too many people combine their social status, their profession and their trading results with who they are. A manager loses his job, a trader makes a big loss and these people fall to pieces, all their psychological structure collapses. Remember once again that we are more than our jobs, and that what we earn at the end of the month is not our identity. I am not a better person or intelligent because I made €10,000 on the financial markets in the month, nor am I pathetic and stupid because I lost that amount. You have to stop identifying with it.
You will know that you have made tremendous progress the day that a loss is no more than information like any other which doesn't change how you think about yourself. The same for a gain. A trader must strive toward psychological strength without weaknesses and for this there is no mystery, you have to work on yourself. Trading can be the path to becoming a more balanced, more accomplished person, more than the path to becoming "rich", I have therefore seen a psychoanalyst, this was my personal path, but there are as many paths as there are people to understanding, growth , and learning to accept losses and recognize mistakes without it being the end of the word.
My technique for cutting my trading losses
Technically, the bulk of my trading focuses on total control of my losses, like Lacan would say, any gains are extra. To do this I set a maximum daily loss. This loss is a fixed monetary value. If during the day, I expect this level of loss, I close my position, I shut down my computer and I leave my home so that I am not tempted to continue. This gives me absolute and amazing comfort for my trading, because I know in advance the maximum loss that I could make the following month if I lost for 22 successive sessions (which has never happened to me). There are few traders who can say that in January 2017 my maximum loss will be: X% or X euros. And yet it is an incredible psychological comfort, I no longer live with uncertainty, I know what I can lose every day, every week, every month. I know that this potential maximum loss will not put me in danger, that I will be there again the following month and the one after that, etc.
This technique of cutting my trading losses has other benefits:
I don't increase my daily loss by trying to "make up" for things. If I tried to make up for a significant loss, 9 times out of 10 I only compounded it at the end of the day.
I will not stupidly waste energy or stress and exhaust myself. I will be fresh in the morning, in full possession of my capabilities. Fatigue and stress management are essential factors for traders.
I leave a market that I don't understand in my time unit, I let it work without me thus giving myself the possibility of being in touch with it the next day.
This system works with iron clad discipline, I no longer act like a child, not accepting losses or losing a game. Moreover, I am now no longer a "bad loser" of any game, it is the game that interests me, not winning or losing. A bad loser has little chance of succeeding as a trader. I have feelings about trading, I am satisfied when I make a good trade, regardless of the financial outcome, I am satisfied by "the act", the aesthetics of trading. There is beauty in trading.
In conclusion, if you can't manage to abide by your rules, your money management, if you don't look after your losses you will sink. You now know that you need to find a solution to discipline yourself, and especially to accept losses. Loss is a normal, natural thing, we have come across it throughout our whole life, whether it is a financial loss, the loss of a loved one, loss of a job, the loss of social status or the loss of a favourite pen. You must learn to mourn and, for a trader, to narcissistically accept that you are not perfect, and that a bad trade does not question who you are. Acceptance of being wrong it what makes us adults, better traders and enables us not to be children any longer. Trading is the pathway to becoming an adult.