For years, I was losing money because I didn’t get it. Not really. You hear it everywhere, it’s probably the best-known trader’s mantra in the world:
Cut Your Losers Fast And Let Your Winners Run
Often, people just skim over this line as something that’s probably true, without any second thought. We know what it means, but we don’t act on it. And we do this all the time in our lives: a smoker will occasionally think: “I should stop smoking”. Many people have this thought in their mind: “I should start exercising”. I should contact my friend whom I haven’t spoken in months. I should go on that world trip I’ve been planning for years.
I should cut my losses faster and let my winners run.
Yet, most of us don’t.
“What the mind of man can conceive and believe, it can achieve.”
The problem is that there are often a huge number of obstacles to overcome when going from dreaming to actually doing. Most smokers have physical hurdles to overcome when they want to stop smoking due to the addiction. Some people might have social anxiety that prevents them from picking up the phone and calling their best friend.
With trading in general and cutting losers and letting winners run in specific, the roadblocks are more subtle. Yet I believe that they’re of the hardest challenges to overcome.
Most of it boils down to loss aversion. Cognitive bias research has shown that people will rather not lose $5 than winning $5. This means that every time you have a losing trade, the natural response will be to just wait and hope it turns around. Conversely, if we have a trade that is currently in the green, our natural instinct will be to take what we can in order to avoid that the trade turns into a loss again.
The Monkey Brain
All of this goes back to evolutionary theory. In prehistoric times, the loss of a day’s food could amount to death, while the gain of an extra day’s food would lead to increased comfort but would not lead to a corresponding increase in life expectancy.
If we found some food growing on a tree, we wouldn’t have left it be, risking the possibility that someone else could take it while we’re waiting for it to grow. Instead, we’ll grab it to be sure that it’s ours to enjoy. We don’t let winners run, we grab what we can because that’s what our monkey mind tells us to do.
It’s hardwired in our DNA to avoid losses at all costs. The result in trading is that we will naturally be averse to closing losing trades. It still has the potential to turn around again, so we prefer to wait for that. Closing the trade at a loss is definitive. It’s something that beginning traders have such difficulties with that they will often not do it or if they do, it will trigger a painful emotion that is often incredibly hard to deal with.
You might start to see why it’s very unnatural to do what we have to do in order to be a successful trader. It often goes against every single fibre in our body and in order to actually do the right thing, we need to condition our mind and our muscle memory to go against that instinct. That’s why the mantra of “cutting losses short and letting winners run” is so powerful. It encompasses the need to do something very unnatural to the human mind, in order to succeed.
Instead of cutting losers fast and letting winners run, beginning traders seem to be hardwired to do the exact opposite. Let’s look at a few examples of the thought process that goes on inside the trader’s minds.
Problem 1: Cutting Winners
Here’s an example of traders cutting winners: the trader gets in on a momentum breakout reversal and the price moves in the right direction. Great! But all of a sudden, there is this unrealized P/L sitting in the trader’s account. The only thing that goes on in the trader mind is this: “I don’t want to lose these gains”.
So in order to protect the potential profits, the trader will monitor the trade very closely. He’s glued to the screen! All of a sudden a small-ish pin bar occurs after a very strong bullish candle. The monkey brain kicks in: “Hey! The price was going your way but it’s reversing! Do something!”.
By now, the trader is mostly driven by instinct and fear of losing as a close second. The only sensible thing to do is to close the trade, right? Bank those gains! The trader decides that he’s in a nice profit already and closes the trade, happy that it didn’t get any worse. Then the price moves further up on a great rally. The trader crawls up into a little ball and cries himself to sleep. 🙂
While the last part might be over dramatised, I still think that a lot of traders (myself included!) can recognise themselves in the above scenario at one time in their trading career. Of course, there will be cases where the price will actually reverse and you’ll lose your unrealized gains, but don’t forget you were in a profit already!
The worst case scenario is that you’ll give those gains back to the market and get out for a break-even. The best-case scenario is that you’ll actually ride the entire trend and have a winner that makes all the small losers seem insignificant. Without a doubt, the potential benefit outweighs the potential risk.
Problem 2: Letting Losers Run
Now, let’s look at an example of letting losers run. A trader takes a long position on a strong breakout candle and the position goes in the right direction. Not long after, however, the price reverses and moves back close to the entry. Here’s the first time that a potential loss could be avoided by closing the position for either a small win or just break-even.
Then, the price moves strongly in the wrong direction. A second opportunity arises to close the position for a small loss. But the trader doesn’t think like that. Instead, the trader is full of hope! The “what if the trade reverses and goes my way again” scenario plays out in the trader’s head and it’s on repeat. It’s a little annoying to think about the other scenario (that it will continue to move towards the stop loss) so it’s easier to just not think about that. Let’s wait and see!
Well, bugger! The trade keeps going in the wrong direction. Opportunity 3 to close the trade for about a 0.6R loss comes along, still way better than taking a full loss! But by now, the trader is fully invested in the trade and wants to be right. The train of thought is now “well, I’m already in such a big loss, I might as well let it play out because I sure as hell won’t take such a big loss now!”.
Changing an opinion and admitting that this particular trade idea might not work out is pretty much like admitting defeat. It’s painful. If there’s only a 10% chance that the trade will turn around, the trader will take that 10% shot. Everything’s better than to face the loss.
Finally, the price shoots down to hit the stop loss. Annoyed by the loss, the trader will think: “well, that’s the market, it happens. There’s nothing I could do about it anyway”. Except that he could.
From Dreaming To Doing
Every trader knows the feeling when they have a losing trade. They don’t want to face a definitive outcome, not yet. Let’s see how the trade plays out, maybe it’ll turn around. Hope is a detrimental companion to traders.
I recently read the following: “once I trade size, I’ll start to be more consistent and conservative”. Good luck with that. Trading doesn’t work like that. When you start trading, you are at the start of a long road where habits are formed. The habits work like muscle memory, after a while they will come naturally to you and it becomes harder and harder to change them, regardless if the habit influences your P/L in a positive or negative way. If you learn the wrong habits and employ the wrong process, you won’t be able to flip a switch and do the right thing once you think the time is right.
Knowing what to do is very different from actually doing it.
If acting on that knowledge is in line with your habits and beliefs, the transition process might go smooth. But we know that this isn’t the case in trading, far from it. To the beginning trader, cutting a loser is a painful process. Letting a winner run sometimes seems unbearable. This shouldn’t be the case, cutting losers is part of trading. It’s like an expense in order to operate your business.
Steps To Do The Right Thing
Which leaves us with one question: how do you actually start doing the right thing?
Just like you would train for a running contest, you need to train to do the right thing in trading. You can’t think yourself from knowing to doing. You need to practice. This is an essential step in order to develop the muscle memory and the belief that cutting losses and letting winners run is the right thing to do. After enough practice, it will come very natural and will cause little to no emotional stress.
The best way to practice is to backtest your strategy and actually execute the actions over and over again. Do this for weeks, months, until you have no problem at all cutting your losses. Use software such as ForexTester 3 to make backtesting easier and see for yourself that it works. Then apply the same things in forward testing, all the while focussing on just this. It needs to become a habit and focused practice is the way to do it.
Trading is gathering a lot of knowledge and if you’ve learned what you need to know, the only obstacle that it often still standing is yourself. Below is a collection of emotion and psychology exercises I’ve used over the years that have helped me deal with cutting my losses and letting winners run. Use them as you see fit:
- Keep screenshots of the charts where you did the right thing and charts where you should’ve cut the trade but didn’t and took a bigger loss. Before every trading session, review these charts to remind you of what you should do.
- Learn to inspect your emotions as they play out. When you’re in a losing position, do you feel fear? Hope? Are you avoiding clues of market behaviour in order to validate your idea of being right? Don’t fall victim to the ostrich effect and ignore clear signs that you should cut this trade.
- Accept that you will lose some trades. Having a win rate of 60% still means that 4 out of 10 trades won’t work out. The faster you accept this and see losing trades not as a failure but as part of the business, the easier trading will become.
- When you’re in a losing position, envision the loser becoming a larger loss. Don’t expect it to turn around. Equally, if you’re in a winning position, try to imagine the price hitting your take profit. This doesn’t mean you shouldn’t be open to market signals that the move is over, but just that you need to have the conviction and patience to stay with your trades if nothing suggests that you should cut it.
- Imagine what your future self would think of your actions. If you cut the trade, that loser wouldn’t have turned into a bigger loser. If you left your winner run, you would have a larger profit by now.
- Finally, don’t look for excuses and accept that the change needs to come from within you. If you blame the market or your broker, you shift the responsibility for change from yourself to another entity, meanwhile excusing yourself from taking action. Facing that your actions reflect your thinking and your beliefs will make it easier to change them.
Finally, focus on the process. Your skill in trading should be measured by how well you follow the process, not by the outcome. Reward the times when you follow your trading plan and don’t focus on the money. A good trade can still lose money and a bad trade can win money.
Also, have a game plan before you enter the trade and stick to it. Write down the levels you want to see the price go to and also write down the conditions that will invalidate your original trading idea. If you follow those guidelines during your trade, you should be fine.
Something which seems so obvious, cuts a lot deeper into the core of how we behave as human beings. Most traders know about the mantra of cutting losses short and letting winners run, but only a few actually put those words to practice and act this way.
Try this: go over your last 20 trades. Could you have cut your losses faster and did the price still move on after you closed your winners? Calculate what the net effect on your P/L would be and formulate a plan based on this. Set rules for how you would cut losses and what would make you close a winner. You’d be surprised by the results.
Accepting to lose money by cutting a losing trade is something that is very hard to do, at least initially. You want to get to a point where it will cause little to no emotional distress, where you fully understand that losing is part of the game, not some terrible trade outcome that should have never happened. The only way to get to this point is to practice a lot. Become comfortable with cutting losers. Become comfortable with allowing your winners the time to develop.
Once you get to this point, you’ll truly understand what it means to cut losers fast and let winners run.