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Losses are Wins

How can a loss be a win?

If it is uncontrolled, it can’t be. But if a disciplined trader cuts his losses short, it can’t be anything but a win.

The smartest trader in the world will have losses, and in some cases less than half of his trades will be profitable.

The trick is to limit your losses while maximizing your gains. Let’s say, for instance, that you maintain the discipline of cutting your loss for any given trade to 5%. Assuming your winners gain at least 5% then a 50-50 win/loss ratio will be profitable---or at least you won't lose any money. Outside of weather forecasting, I know of no other profession in which you can be wrong ½ of the time and remain a success!

This rule should also be applied to long-term investing. One of my primary complaints about a rigid “buy-and-hold” strategy is that the participant, by definition, must suffer through long and terrible market corrections. While the stock may recover in many months or years, there is no logical reason for watching your position deteriorate beyond a point where it can be easily salvaged. Successful investors will usually cut their losses to 7-10% below their buy point.

If the truth were told, the only time I have ever experienced a devastating loss is when I did not follow this rule. I would be so sure of my trade that I just “knew” the stock would recover. Suddenly, my trade was 30% or even 50% deep into the red. Eventually I would no longer be able to bear the pain and would sell at a crippling loss. It would take many weeks of winning trades to recover from such a disaster.

If a trade doesn’t go your way, get out. And, if the stock starts rising after you get out, so what, you still did the right thing. There are trading opportunities every day, so there isn’t any legitimate reason to get whipsawed.

The concept to cut your losses short appears logical on paper, yet in the real world of trading it is often very difficult in the face of uncontrolled emotions. The truth about human nature is that emotions and money are nearly inseparable, and it is inherently difficult to admit that one was wrong about a trade.

There are many books about trading that talk about this problem. Most of them warn against one’s ego, and that you won’t stand a chance until you keep your emotions in check. I do not completely agree with these teachings, however, because most people are unable to complete disconnect from emotion. I for one find it nearly impossible to keep my excitement of a successful trade; I find it equally difficult not to be upset about a loser. With the possible exception of a Vulcan, very few can remain emotionless.

A far better approach is to learn how to channel your emotions correctly, to apply your desires, your goals and your “ego” to the appropriate target. More specifically, the actual problem facing most traders and investorsis the following:

The emotion of hope is applied when they should fear, while the emotion of fear is applied when they should hope.

Anyone who has ever lost substantial amounts of money in the market knows what this is about. When their investment goes south, they hope and hope for a turn-around to recoup their losses. As the position sinks deeper into the hole, each day they hang on and hope that perhaps today will be a better day. But the loss grows and their position worsens.

However, when their position turns positive, they instantly fear they will lose their hard-won profits. The longer they hang on, the more they fear. So they sell their positions too early---without realizing the stock’s full profit potential.

As you can see, they hope when they should have feared, and they fear when they should have hoped. This results in big losses and tiny gains, a sure formula for failure.

Instead of abandoning the emotions of fear and hope, the successful trader simply applies them correctly. If a trade goes against him, his fear forces him get out quickly to minimize the loss. If a trade goes his way, his hope will help him milk the rally for everything its worth. The winning trade is therefore maximized.

Don’t listen to anyone who tells you to remove your emotions from trading. It is nearly impossible. Rather, learn to apply your emotions for a winning result. Become so terrified of losing trades that all of your bad trades are abandoned immediately, without hesitation. You should also be so hopeful for profits that you let your winners run on and on until they run out of steam, especially in a bull market rally.

Apply your emotions to positive results and you can surely win!