Upon entering a trade, most traders have a set risk reward ratio in mind that they are looking to achieve on their trade that guarantees them to make money over the longer term. The fact that your risk reward ratio has to be a certain size when putting it in relation to your winrate has been discussed in depth before on this blog. In the following article we take a close look at a few reasons why traders mismanage their trades and why it’s usually not even their fault.
“Traders sell winners at a 50% higher rate than losers. 60% of sales are winners, while 40% of sales are losers.” – Odean (1998): Volume, volatility, price, and profit when all traders are above average
In amateur tennis most points are won by errors of your opponent and not by your own skill.
The statement above resulted from research and statistical analysis of tennis matches and the idea behind it applies to trading as well. As a trader, especially in the beginning, you don’t have to try to make everything perfect and pay attention to every little detail. In order to survive and build a strong foundation it is much more important that you focus on not making big mistakes that could result in substantial losses. Things on that list include:
- Use a stop loss and stick to it.
- Have a trading plan and follow it. Trades that are not in your plan are not there for a reason.
- Use appropriate risk management. A single trade should not have any major impact on your account balance, positive or negative.
Profits, losses, threats and rewards – We are just monkeys
Holding on to losing trades and selling winners too early result in a skewed risk reward ratio and unprofitable trading results. Holding on to winning trades is psychologically challenging because your unrealized profits could evaporate completely and unrealized losses could still turn into profits.
But the problem goes much deeper. Historically, in order to survive our ancestors had to treat threats and opportunities differently. Losses are threats and we try everything to avoid a sure loss, even if it means gambling and possibly losing much more. In contrast, profits and gains were taken much faster and receiving a sure profit is preferable than gambling to gain a lager reward.
This behavior still exists today and is deeply ingrained in our DNA. Therefore, not cutting trading losses and closing winning trades too early is hard to overcome and a problem traders have to actively work on. A structured approach and regularly reviewing your trading performance is, therefore, a key to your success as a trader.
Word of caution: Don’t go for homeruns
The opposite effect, when traders let winners run too long and hope to land the one big homerun trade that will finally equalize all past losses, is equally dangerous. Most of the time, when traders widen their take profit orders in the hope to make more money than originally planned, they will give back their profits when price reverses. Needless to say that this behavior also ruins the long-term expectancy of your trading strategy.
Conclusion: Increase your performance by overcoming evolutionary hurdles
If you struggle with letting winning trades run, you are not alone and it’s not exclusively your mistake. However, don’t use this as an excuse to keep on making the same mistakes over and over again. Closely monitor your trading activity and how you interact and actively manage your trades. Even better, don’t touch your stop loss and take profit orders after you have entered your trade unless you see valid reasons.