by Rick Ratchford
We've heard it time and time again. And yet, even well-seasoned traders will let this obvious wealth tip go right through their fingers. "Cut your losses and let your profits run."
For most people, something inside them just keeps them from following either part of this plan. And this something usually can be narrowed down to their "gambling" self.
Those who take chances by not cutting their losses short are taking a gamble. They are gambling that the loss they have accumulated so far will soon decrease, bailing them out of a bad spot and possibly providing them with a winner. They will do this rather than take a sure loss, one that they know the amount up front.
For example: A trader may be in the red by $1000. If the trader were to cut his losses now, he knows exactly what his loss is, $1000. However, by staying in a losing trade, he is taking a chance that he might recover. But this also leaves him open for deeper losses of an amount he is not aware of. That known amount is put aside in favor of possibly making it much worse. Thus, a gamble at best.
The odds of such a losing trade is much larger to get worse than better. Yet, for that small possibility of improving a bad situation, the trader gambles with mounting odds against him. Eventually the loss gets to become a size, which forces the trader out. This is how many wipe out their accounts.
There is another side to this. Letting one's profit run. Most traders, especially those who have a series of losses, will jump on the first sign of a profit. They've done their homework, and ended up in a very good trade.
Now there is some profit in the kettle, they immediately abandon their original expectation of a sustained move in their favor, and cash out. Here is where they decide not to put on their gambling persona, out of fear they exit early.
For example: A trader may be in the black by $1000. The move has only gone about one-quarter of the way towards the trader's original expectation for the move. However, fear of losing that $1000 kicks in and the trader cashes out. The problem here is that the odds were now in his favor to continue. A winning trade has a higher probability of continual success, and should be exploited. But fear usually wins out for those who just can't seem to get ahead.
Letting your losses grow, and having the mentality to allow that, but on the opposite side losing that edge and cutting your profits short is a sure recipe for disaster. A good trader must learn to watch those profit situations carefully, but run like heck at the first sign of losses.
What makes it difficult to adhere to these common sense principles is the desire we all have to produce a winner. We want to be right all the time. Who really wants to lose? This inner desire to be right all the time is what hurts even the best of market forecasters.
There exist several market analysts that produce forecasts of outstanding accuracy. Big players may use the advice of these ones due to their incredible ability to determine market action. However, many of these analysts themselves may not do as well as those using their work. Why? Because of the need to be right, the one doing the prediction has his ego tied to his work, which makes it difficult to accept anything that differs from the prediction. Thus, it becomes very difficult for one to trade that which he publicly predicts.
As a market analyst, I know this problem personally. When I try to trade a publicly made prediction, the results are less than favorable. However, whenever a trade is done in private, then the results are wonderful.
It almost starts to feel like making a public prediction destroys the opportunity altogether, as if some mysterious individuals are waiting for the prediction, and then making it a bit more bumpy than expected just for you. That mysterious individual is really our egos.
It's important we remove the need to be right all the time. Take the trade with an open mind, that if it moves in our favor, we will take steps to stay in but safeguard the trade. If it crosses into an area that we pre-defined as the most loss we are willing to take for that trade that we do so and consider that a winning move. Because in the long run, if we cut our losses short, and let our profits run, either way, we've won.