- April 30, 2018
- Posted by: NetPicks
- Categories: Day Trading, Trading Article
Letting your winning trades run and cut your trading losses is a trading rule that we’ve all heard.
The idea is to let the trades that are in profit continue to run in order to make as much as the market is willing to give.
With cutting your losses, you are looking to exit the position and preserve your capital when you identify that your losing trade is not preparing to go into profit. In essence, the trade is not gong to work.
It’s an obvious trading rule and one that you’d think would be easy to follow but for some reason, traders do the opposite when they have an open position. Traders will cut their profits and bank little gains while letting the loser keep on running hoping for a rebound.
Why Do Traders Not Let Winning Trades Run?
Laurie Santos, a professor of psychology at Yale, illustrates this phenomenon superbly 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 gambles; failed to save; stole when they could; used money for food and, on occasion, sex. In other words, they behaved a good 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’re watching your stocks plummet into the red, when you’re watching your house price go down, you’re not going to be able to see that in anything but old evolutionary terms.”
When this is coupled with high levels of uncertainty and ambiguity that we experience when trading any market or any style of trading, you can see that it’s easy to convince ourselves that we should bank some profit or that a big loser might just come back.
The markets are full of information and it’s not difficult to conjure signals that are supportive of our positions (and blank out those that are contradictory) when really there are none.
We all suffer from confirmation bias in one form or another:
- For many, being right trumps being objective and making money and we often see traders giving up on a trading plan and “winging it”
- For some, trading rules are tough to follow
Day trading runs this risk on more occasions than swing trading due to traders having more trading setups and signals to contend with. If you are a day trader, you must be hyper-vigilante to ensure that your trading plan is something you adhere to – win or lose.
It may appear we are hardwired to do exactly the wrong thing that will only make finding trading success – which is already difficult – virtually impossible.
Other Traders Can Hurt You
Other traders may well be looking at similar things to us and be acting on the same information in a competitive manner. This can make taking a loss much harder especially if you hesitate at all.
Looking at a simple but common example: if the market has reached a level where if it breaches it, a cascade of orders flow into the market, a missed exit could mean a far worse price if/when you decide to close out your position.
This in turn feeds the first point and a trader may well hold onto a trade in the hopes that it will “come back”. If it does come back and rewards you with profits, you will never learn that cutting your loses is the best route to go – and can lead you to trading habits that will eventually destroy you.
Confidence To Trade – Ruined
If we look at some trading stats, you’ll see why – your trading stats can be annihilated by just a handful of losing trades or boosted by squeezing a few extra ticks out every trade or hitting the odd home run.
Let’s say that for the reasons already discussed:
- In 2 trades in the set of 30, you blow out
- You take one loss of 6 points
- One loss of 12 points – an additional 14 points of loss in total
- All other trades are taken as normal
Your average trade now drops to just 0.53 points per trade – because of just two trades! And this is a fairly conservative scenario of what can happen when traders don’t take their stops.
Let’s now say you that on 2 trades you take an additional 3 points ). So that’s 2 x 3 to add to the total. Your average now jumps to 1.2 points per trade – an improved figure.
Confidence and emotional balance can be shattered when you lose more than you know you should and galvanized by taking significant winners. Emotional strength is a depletable resource that is called upon when things aren’t going particularly well – so it needs to be built up and nurtured to make sure you don’t lose control.
Over time, having the emotional strength and willpower to continue with your trading plan will help you avoid big losses and trading shocks that go with these.
Letting Winners Run And Losers Get Cut
The day trading rule “Run your winning trades and cut your losers” is a very simple one. But it’s far from straight forward to live by in practice. Understanding the absolute importance of the rule is the first step to fully embracing it.
The next step is to ensure that your trade plan isn’t ambiguous for taking stops and gives you some room to run winners.
So how do you let the winners run?
There are several methods to letting winners run:
- Trailing stops
- Scaling out to reduce risk may make letting winners run a little easier
- Reduce risk as price heads to a set profit target such a risk multiple or significant support or resistance levels
- Hold the position until a technical indicator signal, like a moving average crossover, tells you to exit
The hard part is having the discipline to actually hold the position while fighting the urge to realize the paper profits. But holding on when the urge to exit that is not based on the reality of the market is where the big winners come from.
Losers need an exit strategy just the same as profitable trades do.
The hard part about cutting a losing trade is the hope that the trade will bounce back 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 talking about adverse price movement, it comes in different flavors.
The low momentum moves against your position, giving consideration that it is not a slow grind against your position, are something most would hang on to.
But when momentum steps in against you, you should be close to hitting the exits. Forget about hoping the trade will come back as momentum can lead, and often does, to one more momentum move before price resumes back in the direction of the trend.
Have An Exit Plan
The key point in both cutting losing trades and letting the profits run is to actually have an exit plan for every position you take.
You can do something as simple as scaling out partial position at 1R and move the stop to break-even. When price continues to move in your favor, use swing points or a moving average to look in even more profits.
While taking the time to test which method of running winners suits your style best, a consistent method of letting this trading rule be a part of your trading is most important.
Find something – and stick with it.