Painful Losses: How to Deal With Them

Fact & Fad about Prop-Trading Pt.4

by J.C.Paolini

In this last article of 2013, we shall confront our worst enemies: losses, and ourselves. Through personal experience, I'll show you my journey through torture and pain; how I tried to learn from every loss; how I tried too hard to learn from every loss; how significant every loss was; and finally, how dumb and stubborn I was. Losses are the cost of doing business. There is no way to avoid them, so the best practice is to learn how to manage them early on in your trading career. Get your mind around this task and the pain of trading might even dissipate...

1. Your personal beliefs

 
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“If I find the right system, everything will be fine...”

You need to understand why you're doing what you're doing. If you can't, you won't believe in it. If you don't believe in it, you will not be able to feel it. If you cannot feel it, you will not be able to do it. Logically, you must believe in something in order to have a point of view. And to believe in something you must have the confidence that your beliefs are correct.

Your beliefs and the ex-post validity of your beliefs build your emotional context. And your emotional context influences your perception of reality: we really cannot see things for what they are. We see things for what we believe them to be. The more skewed our emotional context becomes, the less objective we will be in our market view.

Traditional trader training goes something like this: “study this set of conditions; trade only when you see this set of conditions”. But really, how many times do we see the exact same dynamic playing out? And even if the chart looks really similar, are the background conditions the same? Since we're in the realm of probability, how much can we really know about how similar the situations are? Remember that the price of any traded asset is “only” the sum of the market participants' perception of fair value at each point in time. So what we are trading is not something objective.

Even Harry Markowitz stated that before building a mathematical optimization of asset weights, one must have enough experience through observation of the market, to generate beliefs of what may happen.

Bottom line: we need to understand the beliefs that form the numbers. We all strive to be objective, but in the end it's our beliefs that guide us through the day. Said in another way: we usually see what we want to see, and hear what we want to hear. It's tough to see and hear things for what they really are.

And transferring these observations to each and every trade you make, it's like saying that your own assumptions on the outcome of a trade are your beliefs regarding that particular moment and situation. So you are using your beliefs to help you act in a situation which is uncertain.

How does all this translate into something practical? Basically, it's not logical to get angry because a trade went wrong. Because you really can't know all the information that you would have to know in order to make an “informed decision”. We are making educated guesses... “professional coin flipping” as Hugh Hendry calls it. What it takes, to overcome the emotional stress of facing uncertainty day-in and day-out, is a sturdy plan that you can execute blind-folded and that can give you a certain degree of flexibility (in order to cope with various market conditions) within that plan. As we have said in previous articles, you cannot copy somebody else's way of trading. You can learn from others, but you must trade in a way that suits you. Which means, trading in a way that suits your beliefs, your character, your perception of price action.

Understand that you can never know what will happen in the next 5 minutes, in the next 60 minutes, in the next day or week. The future is uncertain. So why get angry at yourself for making a bad decision, when you really have limited responsibility for what can happen?

2. Dealing with trading losses

As an example of how NOT to deal with losses, here is a sketch my fiancée kindly drew of my behavior some time ago...

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1. Deciding to enter

2. Getting Nervous

3. It’s not going straight my way

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4. Shoot, I'll be stopped out! (when in fact it's only a retracement)

5.How do they always know where my stop loss is?!?!

6. Maybe I should quit and become a baker

Remember what was said in the first article? Money is not everything. What is everything, or almost everything, is self-respect. If you link your ego to your money, you'll have a big problem to solve. Too often you see investors attach their ego to their positions. Their portfolio becomes a reflection of themselves. But if all you are is your portfolio, there's not much depth to your persona, is there? If your ego is attached to your performance, then a loss cannot just simply be a loss or the cost of doing business. It's much more: it's a personal failure.

My own mindset, as you can imagine, was totally wrong! I had always been successful at whatever I put my mind to, regardless of the amount of work that I put into it. I was naturally attached to the academic mindset that teaches us very early on “if you work hard and study, you will get high marks”. This translates into many aspects of life where success or failure boils down to how hard you work at something.

The fact is, in the financial markets (as with almost any other entrepreneurial job) you cannot control what happens after you decide to put your money at risk. It's totally opposite to what the modern day society teaches us. Less is more in the markets. Simple trumps complex. The only other ingredient is perseverance: how bad do you want to succeed?

So the correct mindset is something like “if I continue to trade like this, I feel like I can win the war...who cares about 1 battle”. As we will see in the next sections, there are general practices that can help you minimize the impact that any one loss can have on your account, so that you can keep your focus on the longer term objective of consistent profitability. That's one of the main mistakes that (many) retail traders and (some) interbank traders have alike: they come into the business thinking that trading is about all-or-nothing, giant bets that can make you rich quick. The point is that nothing could be further from the truth. Trading is an entrepreneurial business and needs to be treated like such. So you should not let your expectations guide your emotional response to your losses.

Losses are the cost of doing this particular business. But let's put them into context. Trading is tough, but when compared to other jobs you're living a dream: you work for yourself (no one tells you what to do), your expenses are a bare minimum (you can work in underwear, no commuting, the computer doesn't have to be the state of the art), you can decide what hours to work and what to do while you're waiting for the market. Also, if you've got the right attitude and you're well enough capitalized, you can make a satisfying living.

3. How to measure your edge

Surviving as a prop-trader requires an incredible balance. We have taken a little pressure off, seeing as how we are not entirely responsible for what happens after the decision to enter a trade. But do not mistake this for a total limitation of responsibility. On the contrary, you and only you are responsible for your actions. When to trade, what to trade, when to get out, when to hold...all these decisions are yours to make.

Losses will reach you independently from your trading style, frequency...because even the best traders in the world get out of sync with the market every now and again. But what they know is that their experience will allow them to fight back. And also, they know that one bad day cannot compromise their career.

They have created an edge. Traders that succeed have fought countless battles and have learned to survive. They have specialized, working the market from a certain angle. But what's even more important than HOW they tackle the market is HOW MUCH they risk. Here come two magic words: risk management and position size.

a) risk management: to me, risk management means managing the amount of risk that you bring upon yourself. Setups will present themselves more often then you think, but the market environment is not always adequate. Always remember that we can only read a simplified map of reality. We cannot know what's really happening behind the scenes. Let's get past the obvious: what are the odds of playing a setup that apparently gives you a good risk to reward ratio

- before big news releases (NFP, Central Bank meetings, GDP, etc.)
- during low liquidity sessions (Tokyo hours, when US or UK are on Holiday, etc.)

But there are other occasions that are less evident:

- trading long into a stiff resistance or evident swing level
- trading short into a stiff support or evident swing level
- trading a trend following system when there's no evident trend in place
- trading a range in the midst of an evident trend

And finally the big no-no:

- looking too closely at a chart, trying to find a setup

b) position size: believe it or not, the largest difference between professional traders and retail traders is the size of the positions that are traded. Trading books speak about anything from 1% to 5% of your account risked at any one point. My experience tells me something else. Anybody risking 1% on each trade is seriously going to put a dent in their account at a certain point. Since each trade is essentially a random event, then depending on your trade frequency you can have a loosing streak for many reasons (not in sync with the market, trying too hard, getting tired, etc.) and if you're loosing 1% or more per each trade, then it doesn't take much to get up to a 10-15% drawdown.

Drawdowns are another psychological handicap that we should try to avoid. And we CAN avoid them. We can avoid them by limiting the amount of money we risk each time we decide to interact with the market. I prefer to risk anything from 0.1% to 0.5% on one single position, depending on the quality of the context and setup combined.

Also, I pay attention to correlations. If there's a short-USD theme playing out, then I'll try to choose whatever currency is strongest against the greenback first. But if I get other setups against the dollar, I would seriously pay attention before trading them. It would be like doubling my exposure to the same risk-driver. When considering multiple positions at the same time, I would very much prefer to have de-correlated positions, whether in the same asset class or combining different asset classes.

But remember, my preferences are only mine. But that's the point, isn't it? We each need to find our own sweet spot.

Getting down to something mathematical that you can use, in order to track progress (or lack of) is the calculation of your expectancy. Sure, all traders should track their statistics like:

- %Winners
- %Losers
- Average Win
- Average Loss

But there is a way to combine them all to create the Expectancy Rate which is the amount (in pips or in %R) that you are expected to make per each trade, based on your past trades. That is why it's important to have a solid method that you adhere to in a disciplined manner: if you do not always apply a limited number of setups, you will never understand the probability each setup has, and the performance of each setup. And together, those setups are your arsenal with which to tackle the behavior of the markets – so it's probably a good thing to know what the results look like on paper.

(%Winners * Avg. Win) - (%Loss * Avg. Loss) = expectancy

For example:

(0,5 * 10 pips) - (0,5 * 12 pips) = 5 - 6 = –1

This strategy is not sustainable in the long term. You will die by 1000 paper cuts.

Another one:

(0,3 * 20 pips) - (0,7 * 8 pips) = 6.5 - 5.6 = 0.9

This is sustainable because your gains are much larger than losses even if only 30% are winners.

This ratio teaches you the basics of consistency: cut your losses, let you profits run for you OR have many profitable trades where the average winner is only SLIGHTLY smaller than the average looser.

4. Steps to Gaining Emotional Control and Discipline

a. Plan for multiple scenarios

A master Chess player is at least 6 moves ahead of his opponent at every step in the game of Chess. A master trader identifies the market participants in that asset at that moment, determines where the next likely level of support and resistance are, decides a specific price for entry, and has one or more exit strategies planned for that trade before he ever places an order. In other words: he knows what he is going to do before he initiates the trade and has all of his various strategies worked out for all the different scenarios that can happen to that trade. He is prepared for all situations and ready to trade. Finally, if the market fails to perform, his stop loss will get him out safely.

b. Specialize

Too often traders simply follow the crowd. Instead you should develop your own unique trading style. A trading style is not a strategy. It is a set of rules that you adhere to strictly, ignoring rare anomalies that occur in your trading from time to time that go against your rules. If you establish a set of parameters for your trading, write those rules down, and follow them while ignoring the crowd mentality of most retail traders, you will begin to establish strong emotional control in your trading decisions. The trick is writing the parameters down and then sticking to those rules. Emotions want traders to ignore rules. It takes discipline to overcome this drawback.

c. Know your motivation

Don’t trade for the money, because it's the last thing that will keep you going. There are 1000 jobs out there that are more gratifying and that also pay a discrete sum. Trading means finding compromise everywhere. I never feel totally satisfied with a trade. I plan the entry, I plan the management, and at a certain point I exit the trade because it reached my target, or because my trailing stop was hit. Maybe the market accelerated and I decided not to cash out after the bounce. Maybe the market was staying still and I had the opportunity to scratch at par instead of taking a loss. Maybe...maybe...maybe... Actually, the only moments I'm really happy are the lucky trades where I “get the feeling” that something's changing and I bail before I would have been stopped out. But they are few and far in between. You should trade because you can’t imagine doing anything else. Trade because it is the most enjoyable and rewarding profession you can do. You can have a passion for studying charts without letting passion rule your decisions. Highly successful people, in any career, do not do their job because of the money, they do it because they love what they are doing and can’t imagine doing anything else. The money is secondary to doing the job that gives them purpose and self-esteem. Money is not the ultimate motivator, purpose and self-esteem are.

d. Relax and let your profits run

Most traders worry about their profits and check them constantly. I also had a tough time getting up and going to the bathroom when I had a position running. And I would take my laptop to the bathroom with me, believe it or not! I would get elated when price moved up a few pips and get frantic when price moved down a few pips. This is one of the biggest mistakes traders make and it creates an emotional state of mind that lacks control.

Checking your profits or losses constantly is obsessive. And it is not based on facts.

Most traders assume that if they are in profit they have made that money. Conversely, if they are losing money, then they take the stance that this is just a momentary loss and not a real loss. This is how most traders think, but it is the opposite of what they should be thinking.

To gain control over emotions and to gain discipline in your trading you must view it in another way: when price moves against you, you immediately have a loss, even before you are taken out. If price moves a few pips in your favor then you have the potential for profits. But until you exit that trade you do not have profits. Only when you close the position do you actually have profits. A loss is immediate, even before you sell. Approaching your positions in this manner is critical to maintaining the proper viewpoint when trading.

If you say to yourself that a losing trade is going to turn around, you immediately increase your emotional level so that instead of thinking logically, you are hoping and praying for a miracle. This will cause you to miss subtle chart patterns that are telling you to cut the trade and move on. If you are in a profitable trade and you say to yourself “look at all the money I’ve made!” you are in an emotional euphoric state of mind. Euphoria makes traders feel invincible, and you will ignore weakening patterns. The result of this euphoric state of mind is that you will either hold a trade too long, or you will take greater risks in your next few trades that will result in losses due to poor analysis dominated by emotions and a false sense of invincibility.

The solution is to recognize these emotional patterns. As traders, we are never brilliant. We will profit if we are able find an ideal trade during great market conditions for that trade. To quell the euphoria, do not trade after you have made a huge profit. Take a few days to settle down. This is not gambling where you can say to yourself “I’m on a roll!” You are most definitely NOT on a roll. Trading takes logical analysis, not super-heated emotions of feeling brilliant. If you stop trading and let your emotions calm down, you will see huge improvements in your consistency of profitability.

e. Know your risk tolerance

Two chronic complaints from traders is that the Dealers/Market Makers are ‘out to get them’ and that stop losses don’t work. Both are fallacies steeped in conditions that create deep emotional trading patterns. First, nobody is out to get you. The truth is that the Dealer/Market Makers' primary role is to keep the markets orderly by buying or selling their own inventory IF there are no buyers or sellers for an order. That is something that occurs only in large lot activity or illiquid markets. If your stop loss gets taken out and then the market moves up (or down) this is not because a Market Maker saw your stop loss and decided to take you out of your tiny share lot trade, it occurred because too many small traders all used the same percentage stop loss and thereby accidentally created an imbalance of order flow that triggered a series of automatic selling that caused you to be taken out.

The second myth: Stop losses don’t work. The problem is that you are probably trading way beyond your risk tolerance. Risk tolerance is different for each trader and most traders don’t even know what their risk tolerance is, nor do they consider this when entering a trade. Think of this: a trader places a stop loss that is evidently too tight for the normal price action patterns because he is afraid to lose money. He thinks that if he keeps a very tight stop, then he is only risking a small amount of money. Often these stop losses are based on a specific dollar amount that has nothing to do the with the chart price action. The trade is too high risk for his risk tolerance but instead of discarding the trade in search of a trade within his risk tolerance, or changing the position size to suit the situation, he trades emotionally by convincing himself the trade will make him a lot of money and that if he just keeps a tighter stop then it is okay. The reality is that by keeping a tighter stop than the price action pattern requires, he is actually increasing his risk for that trade as the normal price action will wipe out that stop loss quickly. And that trader’s normal emotional response is that stop losses don’t work.

It's best not to use common and popular percentage stop losses. Use proper stop losses hidden away from where the normal price fluctuations could get to. Properly placed stop losses do work. They protect you from the occasional trade that goes against you. And they tell you if the risk of the trade is too high – a common condition of an overextended move, ripe for profit taking by large lot traders. For example, if you get a setup that has a 50 pip stop loss, but price has already moved 100% of it's average daily range, is it really a high probability scenario? Improperly placed stop losses increase your risk and are an indication that you are trading outside of your risk tolerance.

f. Know your emotional luggage

Emotional luggage is probably the least known and least understood aspect of trading emotionally. Most traders don’t even realize or accept how much it impacts their trading. The most common symptom of this problem is the trader who suddenly makes some good trades and profits and is feeling great about his trading but the next few trades are disasters that leave him feeling bewildered and frustrated. Your emotional luggage is a culmination of many years of your professional adult work experience, your childhood experiences, your general feelings about money, and your educational experiences which create your perception of your worth to the society you live in. These perceptions are a major emotional constraint in your trading. It is not created by your trading, but has been with you for many years prior to even thinking about becoming a trader. It influences your life far more than you probably realize. It can keep you from earning more money. And it can thwart and hinder your trading profitability. It keeps you from making a higher income and it sabotages your trading whenever you exceed your social perception of self-worth. It is one of the primary reasons some traders make a lot of money while others have mediocre results. Someone once said that “our current self is taken by the hand and guided through life's experiences by our past self”. What this means is that who you are today, the level that your trading is at today, the awareness you have today are totally different then they were time ago. Do not get anchored to your past results in any aspect of life.

g. Keep good records

Every good trader I know keep detailed records of his/her trades. Maintain accurate records of every transaction you make. Document all of your trading efforts in a Trading Journal. That way you can easily go back and study what happened before and compare to current patterns. Professionals never stop learning. They know that being a professional requires constant training and education to continue to hone skills and expertise and to keep up with the ever changing world we live in. Nothing is stagnant, life is constantly changing and so is the market.

h. Test your ideas before going live

Too often traders learn a new strategy or think of a new theory about trading and then rush in to the market without testing that theory or strategy. The end result is losses. Often huge losses. A doctor wouldn’t test a theory on a live patient. The ideal way to test your theories or ideas is to simulate trade the current market for a period of time. Many traders attempt to back-test theories but the problem is that the market is constantly changing. Just think of all the Carry Trade strategies that worked up until 2007 and after that just ceased to function at all! Reminder: It takes at least 100 trades to fully test a theory. Many traders test a theory on a few trades and then go live in the market only to have disappointing results.

i. Strive for quality, not quantity

Most retail traders trade too often. They react to the market instead of anticipating the market. Brokers, clearing houses, the news media, stock and options seminars, the exchanges, all benefit from retail traders' activity. The more trades you do, the more profits your broker, clearing house, news media, and others make. They want you to trade as often as possible and they don’t care if you make money or lose money so long as you trade, trade, trade. As we have said earlier on, less is more. If you made money 9 out of 10 trades and those trades were highly profitable with the one having a small loss, versus 100 trades where 55 trades were losses, and 45 were profitable, which group would make you more take home profits? Remember: quality, not quantity. Every time you trade, there are costs involved. If you have many losing trades it is more than just the loss of that trade, it is the cost of the order, the time you spent on it, and the overhead you incur when trading as a business.

j. Take responsibility for your decisions

This is different from taking responsibility for losses, which we have covered before. When a trader lacks self-confidence, they run around trying to find someone else to make their decisions for them – even sub-consciously. I failed miserably when I started trading a strategy I had created, and then I fell into this same trap. I searched for “high probability strategies” trying to emulate what other profitable traders were doing. I was an insecure trader and my performance and success in the market was negligible.

To be highly successful at anything, you must take responsibility for your own actions. You must learn to depend upon yourself and your ability to make sound decisions. If you are a novice trader, just starting to trade with limited experience, you might want to find a mentor to guide you while you develop your self-confidence and skills for trading. Don’t listen to gurus and TV commentators as this will only confuse you. Don't follow forums. Find someone who can help you develop your own unique trading style and wants to teach you to becoming self-reliant.

If you are experienced but have gotten into the bad habit of getting angry after a bad trade, and blame the market, your broker, your trading buddy, your spouse, or whatever for that bad trade, then you need to work on taking charge of your trading. This is the symptom of someone who lacks self-confidence in their own trading decisions. If you are not confident you can choose good trades, then you should not be trading live in the market. This usually means you didn’t paper trade or simulate trade long enough when you were first learning to trade.

The solution is simple: instead of paying tuition to the market itself, pay a mentor and stop trading live. Go back to the simulator. It doesn’t matter whether it takes a few weeks or a few months. Until you are confident that you and you alone, are fully capable of consistently choosing good trades, you will never be successful. If you aren’t successful paper trading or simulator trading then you will not be successful trading live in the market. One bad trade, or a series of losses, cannot possibly ruin your self-confidence if you know what you're doing, if you're confident and prepared.

In summary: some people say that trading is 20% technique and 80% psychology. While it is necessary to learn the skillset that allows a trader to understand market dynamics, it is much harder to overcome the mental blocks that can sabotage our success. In this article, I have explored all the possible “mental traps” that I have fought, thought about or found in other traders I have spoken to. In order to be a good prop-trader, you will need to overcome your worst fears and you will become a much better person if you're able to push through all the mental blocks that can hold you back.

Good Luck!