Run Your Winning Trades and Cut Your Losers

Okay so this is one of those day trading rules that’s pretty darn obvious, right? Run your winning trades and cut your losers – try to let your winning trades make you as much money as possible and cut your losing trades as soon as you identify that they’ve turned bad. So why then if it’s so obvious, should it even be a saying? Why should it be that traders find it so hard to live by and in fact, do the very opposite in practice?

Why it’s so hard

First of all, following this particular day trading rule is so hard because of the natural tendency to be risky with losses and safe with winners. If you choose to not take your stop, the loss is not guaranteed and conversely, you can guarantee a winning trade by taking yourself out of a positive trade. Laurie Santos, a professor of psychology at Yale, illustrates this phenomenon superbly well in her 2010 Ted Talk.

When this is coupled with high levels of uncertainty and ambiguity that we experience in the heat of the daily trading battle, 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.

But there’s another facet to this problem – other traders may well be looking at similar things to us and therefore acting on the same information in a competitive manner. In particular, this can make taking a loss much harder especially if you hesitate at all. 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. This in turn feeds the first point and a trader may well hold onto a trade in the hopes that it will “come back”.

Why you have to change your mindset

Some trading stats

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 significantly by squeezing a few extra ticks out every trade or hitting the odd home run.

Let’s take an example of a set of 30 trades in the E-mini S&P 500 futures (ES). You have a 2 point stop and a 3 point target and your win rate is 60%. This means that on an average set of trades, you’ll have 18 x 3 point winners and 12 x 2 point losers. So your average per trade will be 1 point.

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 and 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 tradebecause 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 (hardly a home run). So that’s 2 x 3 to add to the total. Your average now jumps to 1.2 points per trade – a vastly improved figure.

Emotional balance

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.

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. Then the final step is practice, practice, practice.

Trade well.

For more updates from Mark and the team at NetPicks, be sure to visit their trading tips blog at NetPicks.com.