Most traders focus on cutting off strings of losses. But, if you apply proper risk management techniques, then strings of losses won’t take you out of the game. A much bigger problem, which many traders overlook, is that missing out on winners can hurt you far worse than losses. Your overall positive expectancy is based on your winners outpacing your losers, but for this to work out, you actually need to have the winners. And, you can’t have winners if you aren’t trading.

Based on that old saying “you can’t hit the ball if you don’t swing the bat,” I call this article “Keep Swinging!”

Important Caveats!

Many traders are not ready to take this advice, yet. The best thing for their accounts really is to walk away, for one or both of these two reasons:

• … because they let the losses affect their judgement. My article on how to recover from a loss points out that recovery is an aspect of your mindset, rather than your account balance. If you are not mentally recovering from your losses, walk away (and try to get better at recovering quickly).
• … because they do not have a system that works for them, and that they believe in. I don’t mean you need a mechanical system; even a completely discretionary system is fine. But, you have to know, either from testing, or your track record, or whatever, that it works and has a positive expectancy. If you are testing the waters and trying things out, please only make tiny bets if you trade at all.

So, if either of these two issues applies to you, by all means walk away from losses and regroup. But, it’s once you’ve addressed these two issues that your profits and confidence can really soar.

Excuses, Excuses…

In the past, when I had a string of losses, I would often quit for the day, or even take a couple days off. I would tell myself things like:

1. I must be off today… I better get away and get re-centered
2. The market’s mood is changing… I better stay away until it starts acting better
3. I am just unlucky today… better to save my capital and come back strong tomorrow

But those are just excuses, when you get down to it. I’d make those excuses because, when I was losing, I wanted to walk away. It’s hard on the ego to lose. But, I’ve come to realize that walking away is the last thing I should do.

Why not Walk Away?

I am going to assume here that one of your main goals as a trader is to be consistently profitable. That’s not to say you should be focused on making up your losses, or on the amount of money you have made, when trading. But, since we all know we’re trading in order to make money, it’s good to analyze how best to actually do that!

If you recall, in my article about how to be consistently profitable, I point out that there are two main factors affecting profitability. They are:

• the profit factor of your trading performance
• the number of trades you take

The profit factor is explained in the linked article, and is a somewhat fixed aspect of your trading system. The number of trades you take is up to you, though! The article shows that the more trades you find and take, the better the chances that you will be profitable that day (or week, or month… whatever your time frame is).

So, a trader that has a “three strikes and you take the rest of the day off” rule is actually crippling their chances of being profitable. By stopping in the red, they’ve dropped their chance of profitability that day to 0%, by default. But, even worse, the time off also means less trades will be taken that week. This lowers the chances that they will be profitable that week, and so on.

Another way to look at it: If you have a 60% win rate, then you can expect four out of ten trades to be losers. But, you don’t know which four they will be, and you shouldn’t care. If those four happen to be the first four of the day, then why would you stop, rather than go on to have your expected six wins? It’s not rational. Recall the caveats from earlier. We are assuming here that your losses don’t affect your judgement or performance. If so, then the outcome of the next trade has nothing to do with the previous trades. Your chances are still governed by your statistical win rate.

Of course, due to the nature of probability, there is always a chance you might keep trading and go on to have 10 losses. But, that’s what good risk management and money management are for. And, the fastest way to get back into the green is to keep trading.

You don’t make money by not trading.

Some traders, rather than quitting for the day, start placing smaller bets. This also cripples their chances of profitability. Say you cut your bets in half. Now you need twice as many wins as you needed before to get back in the green. I am a firm believer in risking a percentage of equity, so I do think you should trade smaller when your account is in a drawdown. But, that’s an adjustment to make each month or so. Not after every trade! I’ll go back to those caveats: if your judgement is not impacted, and you have a solid system, there is no good reason to cut your risk because of a few losses.

My Excuses Were Bogus, Anyway

Let’s look at the excuses I mentioned earlier, one by one. These were just three examples from my trading… Perhaps you can think of more, from yours.

First: “I must be off today.” Seriously? If I get all introspective, I can tell if I am truly off or not. I remember, one day last month, I kept pulling the trigger maybe a half-second too late, on three trades in a row. It was seriously cutting into my profits. I was pretty sure the markets hadn’t sped up, so I realized that I must have had slow reflexes that day. Maybe I was distracted, or whatever… doesn’t matter. That’s the time to walk away. Most days, though, I am just fine, and the “I must be off” theory is just a bogus ego band-aid.

Second, “the market mood must be changing.” Really? If so, then why are my setups still setting up? I have not compiled statistics to prove this (and I doubt statistics would prove it, actually), but it seems like the first setup I skip always ends up being a big winner. Surely most traders have experienced this. And of course then you try the following setup, lose again, and feel just terrible. Losses suck, but missed gains followed by more losses really sucks. Moral of the story: take all your setups, when they appear.

Two weeks ago, on a Monday, my first three trades were all small losses. This did not feel good at all. I literally thought to myself “the markets aren’t acting right.” When I realized what I was saying, I got up, walked around a bit, and had a snack. When I felt normal again, I kept trading (I was extra careful to only consider “perfect” setups, to be sure). I made two more trades, for two wins, and ended the day at break-even. I’m sure you know the emotional difference between ending the day oh-for-three, and ending the day break-even. It’s a huge freakin’ difference.

At this point, you might be objecting: “but, sometimes the markets really aren’t conducive to my trading style.” My response is: whatever criteria you are talking about should be a precondition of your trading setups. In other words, if you are correct, then on those days you shouldn’t be able to find any trades to take. If you have loosely-defined setups which give false positives when the market mood shifts, then improve your setups and keep taking every good one you find. But, please wait until you have a lot of data to back you up! Remember that it’s a common misconception that you can judge what works quickly!

Third, “I am just unlucky today.” Yes, many times we feel like we are down on our luck. But, what does that really mean? I’m not sure I can say. It’s not like we literally have a luck jar that can be running low on luck juice. This is such a flimsy excuse for quitting! In my article on how to tell if you are a good trader, I pointed out:

“If a trader has a win rate of 40%, then there is a 7.8% chance that any string of five consecutive trades are all losses. Even at a 60% win rate, the chance is 1%. So, after hundreds of trades, I should actually be surprised if there are not a few strings of 5 or more losses! It’s to be expected, and not a reflection on my ability to trade in any way.”

Earlier this week, I scratched three attempts to scalp HD. Three times, in quick succession! It kept stalling, and I kept bailing. Then, it would retreat a few cents, and set right back up at the number I was watching. After the third scratch, I said “Enough! I am just not having any luck with HD” and I passed on the fourth setup. You can guess that the fourth one ran far enough to make a profit even after covering the commissions on the other three tries! That pissed me off, because it was clearly a mistake on my part to ignore a good setup because of previous failures. Once I got calm again, I went on to trade MNT and SLAB for wins, ending the day in the green.

It Goes for Winning Streaks, Too

I am personally still guilty of this mistake: If I have a string of winners during the day, I tend to take the rest of the day off. I am back to worrying that my “luck jar” will run out of “luck juice,” I guess. This is just as bad as stopping due to losses (though it doesn’t feel nearly as bad). More trades is always statistically better. Say I had 5 wins in a row, so I quit. The next day I have 10 losses. I think I would probably wish I had stuck around for a potential 5 more wins on my good day. So, this is something I’m working on.

As with strings of losses, the key here is to not let the strings of wins affect your judgement. If you start feeling like a trading god who can do no wrong, and get overenthusiastic, then by all means walk away (and work on improving in this area). I don’t get the god complex, but I have a kind of post-win lethargy. I lose all will to trade for a while. I think it’s just fear of losing my gains in disguise, and I’m working on just forgetting my previous trades, whether they are wins or losses.

So Keep Swinging

I view ideas like cutting down risk or stopping trading after a string of losses kind of like training wheels on a bicycle. They keep you from hurting yourself when you are still learning, and uncoordinated. Once you know what you’re doing, and have the proper confidence, take the training wheels off! Leave those crutches behind.

He are three principles that I think are important for success in the markets. They are all related to nature in some way, so I’ve grouped them together.

Key #1: Be Yourself

Summary: Nature (and the markets) punish those who go against the flow. You have to trade in harmony with your personality, and your means, and your environment. Otherwise, you will find yourself extinct.

When a bird on the ground wants to get to a tree branch, it doesn’t try to climb the tree. And it’s a good thing, too, since it would probably really suck at tree climbing. Everywhere you look in nature, you can see similar examples. For instance, trees don’t walk over to a nice spot, take out a shovel, and plant their seeds. Instead, they work in harmony with their environment (sometimes in strange and surprising ways) to “accomplish” their propagation.

I put “accomplish” in quotes, because there really is no effort involved. Birds don’t struggle to fly… they just fly. In nature, a predominant theme is to take the path of least resistance, and everything in nature seems to have developed an easy balance. Taoists have a concept of “wu wei” that describes this idea of “going with the flow” and “action without force.”

Some people believe that a higher power designed everything this way. Others prefer to think in terms of natural selection. But, regardless of how you think it got here, it’s here. Nature is complex, and chaotic, and does not reward those who fight against it. And, the stock markets are pretty much the same way.

Take me, for example. I don’t have a long-term viewpoint on stocks, or the overall markets. That stuff bores me. My broker’s commission structure does not lend itself well to scaling in and out of trades (at least not more than 2 entries/exits, anyway). I don’t have a large enough account to hold more than 2 or 3 positions at once. So, I am obviously not going to try to trade like a hedge fund. If I did, I would be the bird climbing the tree.

At the same time, if you do have a ton of money to invest over a long haul, there’s no way you should be trading like I do. It’s not practical. If you have too many distractions during certain hours, you shouldn’t try to trade through those hours. Et cetera, et cetera.

I wrote an article last year on this topic, called Trade In Harmony With Your Personality. It has more examples, and suggestions about how you might go about refining your style to fit you better.

Key #2: Stop Pretending You Control the Markets

Summary: When it starts to rain, you can seek shelter, or you can get wet. Nature doesn’t give you any other choices, and neither do the markets.

When my cats jump up on my countertops, they do their best to plan beforehand. They step back and look for any objects big enough to see from the ground. They stand on their hind legs and try to peek at their desired landing area. But, they still can’t see enough to be sure. At some point, they have to use their past experience, and their best guesses, and just jump. This is the same thing we do when we trade stocks.

I know what I expect my target stock to do, based on all the charts I’ve seen in the past. I look at various indicators, and market mood, to try to confirm my guesses. In the end, though, I just have to jump in and see what happens.

The difference between cats and novice traders is: when the cat doesn’t like the situation it finds, it jumps right back down. Sometimes, it’s able to change course in mid-air, not even landing at all. Novice traders, on the other hand, jump into a stock trade, and stick with it no matter what. They seem to have an infinite capacity for denial.

Say a stock trader opens a position expecting a run, and the price action stalls instead. Most traders I’ve met take this as a cue to start doing further analysis. “It’s still got good tone compared to its sector,” they might conclude (or any number of other reasons why the trade is still looking great). A lot of them also focus on what they want to happen (as in “I’ll wait for it to move just a few more cents and I’ll get out”), as if the market cares.

Some see reality (perhaps whining “hey, the trade’s stalled out” in some public forum), but they still do not close out their position. Another common reaction is to root for the stock, or otherwise somehow try to mentally prop it up.

All these reactions are stressful, and ultimately useless. Be like the cat. The cat knows it can always jump back up again, whenever it wants to. Deal with your situation.

Today (6/20/2007) on Wallstreak, I gave an example along these lines from a trade I made in SLAB. It was a stock I expected to run, but it stalled instead so I got right out. That’s just this article’s example, though… any time the markets don’t do what you thought, just get out. If you expect an uptrend and it makes a lower high or lower low, stop making excuses for it and get out. Got it? Good.

Key #3: See What’s Really There

Summary: Look at the markets like an artist looks at nature. Don’t abstract away all the richness of the market environment.

Nature is extremely rich and complex, but most of the time people are almost literally blind to it. We label things and box them into abstractions. In math and science, this is a really useful human ability. When living your life, I’d say it’s more of a liability.

When you look outside, do you see “the lawn” or do you see “millions of individual blades of grass, all different”? You filter out most of your available sensory information, most of the time. Most of the day, you probably don’t feel your clothes, or hear your refrigerator humming, for instance. But, if you choose to, you can.

In the markets, too, many of us throw concepts around and ignore the richness underneath. “Hammer” candle. “Liquid” stock. “Choppy” day. “Capitulation” selling. These simplifications make it easy to communicate in some basic way with other traders, in the same way as you might tell someone in passing that you have two trees in your yard.

That’s fine for a casual observer, but an artist would want to see those trees, and observe their individual shape, color, and texture. An artist pays attention to the individual leaves. And just as every tree has depth and complexity, every candle on your chart has unique time, volume, and trade rate characteristics (to name a few). You might be surprised what you can notice, if you actively watch the detail.