Trading is an attractive prospect to many as it offers opportunities to increase wealth, can improve your financial health, and can even be a flexible and enjoyable way of earning a living. However, many resources that provide guidance on trading tend to offer an overly optimistic view of a trader’s potential performance, ignoring the inevitability of encountering losses. As a trader, it is crucial to learn how to deal with losses, as they are an unavoidable aspect of trading. Even with thorough and logical preparation, traders are not always correct about their predictions due to random events or the unpredictable nature of the stock market. In this article, we will outline strategies and principles for dealing with trading losses to ensure that you can manage your risks effectively and prevent compromising your ability to trade. Understanding how to handle losses can make the difference between long-term success and failure in trading. By developing a disciplined approach and a willingness to learn from your mistakes, you can become a successful trader and reap the rewards that come with it. It is important to note that we will not be going through any trading strategies, just dealing with the ramifications of a loss.
“Good” vs “Bad” Losses
As mentioned before, it is important to understand that encountering losses is an inevitable part of the trading journey. The key to managing losses effectively is to ensure that they are “good” losses and not “bad” losses. That being said, it is unlikely you are going to make it through your trading career without encountering a bad loss. Good losses are losses that fit within your overall trading strategy, whereas bad losses are losses that are incurred outside of your trading strategy. It is crucial to recognize that good losses may be larger than bad losses, but the distinction is the nature of the loss. It is also important to note that both types of losses are bound to happen and that both can be valuable learning opportunities.
It is natural to feel upset or disappointed when you incur losses, but it is vital to remember that it is a normal part of the trading process. One way to approach losses is to view them as an opportunity to evaluate your strategy, identify weaknesses, and refine your approach. By analysing your losses and determining whether they are good or bad losses, you can identify failures in your trading strategy or your psychological reaction to a loss. Your psychological reaction to a loss determines how you should approach your trades, and we will go into more detail about this below. Ultimately, it is crucial to maintain a positive and realistic mindset when dealing with losses. Recognize that they are a natural part of the trading process, and with a disciplined approach and a willingness to learn, you can become an even more successful trader in the long run.
Dealing With Losses
Dealing with trading losses is not just about learning from mistakes; It’s also about handling them emotionally. This can be a challenging task, as it requires you to be self-aware and in tune with your own reactions. For instance, if you are the kind of person who needs immediate closure from a loss, it is important to evaluate and learn from your loss as soon as possible. On the other hand, if you tend to get easily disappointed by failure, it might be a good idea to take a break from trading so that when you return, you have had time to process the loss and won’t let it govern your future decision-making. While it is important to work hard to improve your trading skills, it is also essential to maintain a good work-life balance and not let losses consume your life.
When dealing with losses, there are certain things that you should avoid doing. These include ignoring the losses or adopting a care-free attitude, as well as blaming external factors such as mentors or trading resources for your losses. While it is important to critically evaluate any information provided to you, it is ultimately your decision to make, and you should take responsibility for your actions (this includes your choices to choose a particular mentor/resource).
On the other hand, there are certain positive steps that you can take when dealing with losses. These include examining your emotional reaction to losses, such as feeling sad or angry, and to profitable trades, such as becoming too greedy. By understanding your emotional responses, you can better control them and make more rational decisions. It is also important to take the time to reflect on your trading strategy and identify any weaknesses or areas for improvement. By doing so, you can turn losses into valuable learning opportunities and ultimately become a better trader.
Learning From a Loss
When learning from trading losses, the key is to use the experience positively. This means examining the cause of the loss, diagnosing the issue, and taking action to prevent this issue from occurring again in the future. The first step is to determine whether the loss was due to a flaw in your trading strategy or off-strategy behaviour. If there’s a problem with your strategy, it may be related to your stop-loss settings, the indicators you are using, or the fact that you didn’t test your strategy properly, to give just a few examples. Issues with your strategy are often easier to address, as they require a more analytical approach (it is a good idea to use a trading journal to make this step easier).
If the loss is due to your off-strategy behaviours, it requires a more introspective look at your personality. Off-strategy behaviours can be induced by Fear Of Missing Out (FOMO), chasing losses, and stress. For example, let’s say you invest in a stock that has a 50% chance of appreciating by 10% and a 50% chance of depreciating by 10% in any given time period (this makes it easier to explain mathematically). Let’s also say that you will always chase your losses so that you will keep investing until you have made a positive profit of £10, having made an initial investment of £100. In the first time period, you may make a profit of £10 or a loss of £10 with equal chance. If you incurred a loss in the first period, to make a profit of £10 in the following period, if you have had a loss in the first period, you need to buy more stock so that if the stock rises by 10%, the profit gained from this rise includes the £10 you wanted to begin with and the £10 that you have already lost. Therefore, you will need to buy £110 more stock. Then you again have a chance of losing, this time a greater amount of money. It only takes three losses in a row for you to have lost an amount equivalent to half your initial investment, and this will happen with a chance of 12.5%. There is no guarantee that you will keep being able to buy more stock to improve your losses, and so you have compromised your trading position by chasing your losses. This is an extreme and incredibly oversimplified example, but it just goes to show the danger of chasing your losses without objectively thinking about your chances of making profits. On this note, the example above perfectly demonstrates the concept of the gambler’s fallacy, when individuals believe independent events are influenced by the outcome of previous independent events. It is worth doing research on the different cognitive biases that most individuals will exhibit when presented with similar situations, as you will be able to recognise when your own behaviour is exhibiting bias.
It’s also important to note that there may be a third option for a loss that hasn’t been discussed yet: a random loss due to market forces that cannot be predicted. In this case, it’s essential to be impartial when rationalizing the loss and to be entirely honest with yourself at all times. It may be easy to attribute all losses to random, unavoidable, and unpredictable changes to the market, but this will harm your trading ability as you will never learn from your mistakes.
Once you’ve diagnosed the cause of the loss, you can take steps to address the issue. If there’s a problem with your strategy, you may need to revise your approach, test it thoroughly, or seek out the advice of a mentor or professional trader. If it’s an off-strategy issue, you may need to work on developing emotional intelligence, managing stress, or adopting greater discipline with regards to your trading habits.
Trading Losses Takeaways
In conclusion, trading can be an exciting and flexible way to earn a living and improve your financial health. However, it is important to recognize that encountering losses is an inevitable part of the trading journey. Good losses are losses that fit within your overall trading strategy, while bad losses are losses that are incurred outside of your trading strategy. Regardless of the type of loss, it is essential to learn from it and handle it effectively, both analytically and emotionally. Taking the time to reflect on your trading strategy and identify weaknesses or areas for improvement is vital to becoming a better trader. If the loss is due to a flaw in your trading strategy, it may be related to your stop-loss settings, the indicators you are using, or the fact that you didn’t test your strategy properly. In contrast, if it is due to off-strategy behaviour, it requires introspection. In either case, understanding the cause of the loss and taking action to address it can help you turn losses into valuable learning opportunities, ultimately leading to long-term success as a trader.