Recently I was going through my trading notes and I happened to come across a trade that I documented a while back. And after looking it over, I realized it can serve as a good lesson to present to newer traders who may not realize that they are also making this costly mistake.
Somewhere in our learning curve, we have all done the old “let’s move the stop away from the market because I know this market is going to bounce as soon as I get stopped out” trade. Or worse, we have done the “I will use a mental stop, so I don’t get shaken out all the time” trade.
My worst trade, as it turns out, is actually a three-pip winner. How can a profitable trade be a bad trade? The question you have to consider is what was the risk? This particular trade turned out to have a 20-pip stop. So I risked 20 pips to make three. Does this make sense? If it does, you’re not going to have an account for very long.
The problem with this trade is not only that the risk is way out of proportion, but that if it works out, it reinforces ineffective trading behavior that will cost you money in the future. For example, when you get into the anti-stop mentality and you’re getting away with your cutting your winner short and letting your loser run method, you open yourself up to the possibility of the one big run against you that never comes back. Any experienced trader knows the one run I am talking about.
In a very tight range bound market, your small profit big stop strategy will work. So what do we do? We start adding to the losing position because we think we’re a market maker now. As soon as the market breaks in the wrong direction, the losses usually wipe out all of the small gains in a matter of minutes. When you go from owning the market to giving back everything plus some, your confidence goes out the window as well.
In the long run, the series of small wins do not make up for the loss of capital and confidence that you will get caught in. Knowing this will allow you to judge such behavior as ineffective, even though the short term illusion can be so convincing. Remember it’s your performance over a large number of trades that carries any meaning, not a small run of random wins.
Much of the time this behavior results from a lacking game plan, or a very reactionary style of trading. The whole point of a trading plan is to define your actions before you get into situations where emotion can cause you to react to market information. The more defined your plan, the better prepared you are to manage your feelings when dealing with the stress and torment of noisy price action.
The formula for success in trading is to cut losses short (small losses) and let winners runs (win more than you lose). When you get lured into the “anti-stop” mentality, you’re now set up to do the exact opposite. Human nature works against us in this game and we have to do everything we can to rewire our behavior so that we work with the market and gain from those who choose to react to its random nature.
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Marc Principato, CMT
*No Relevant Positions