Monday, May 19, 2014

Cutting Losses and Letting Profits Ride

Hundreds of trading books throughout the ages have repeated the phrase "cut losses and let profits ride".  Interviews with top traders bear witness to the fact that trading is about cutting your losses short and allowing your profitable trades to remain open.  Rather than simply trusting these individuals, we should seek to understand the rationale behind this rule of trading.

The markets are essentially random.  A trend will occasionally emerge from market noise, but on average, most trading signals are false.  This does not mean that it is impossible to make money in the markets, however.

Think about this.  Let's say that you are trading a strategy in which you are able to, at most lose 1%, but are able to keep winning trades open indefinitely.  In other words, when you're wrong, you lose 1%, but when you are right, you can win magnitudes more.  A trader using this type of strategy will only need to win a handful of trades to more than pay for his losing trades.  For example, if 70% of your trades result in a 1% loss but 30% of your trades result in an average gain of 6%, after several hundred trades, you would be very successful.

Here is a graphic representation of this trader (70% of trades result in 1% loss, 30% of trades result in 6% gain).  This is a random simulation of 100 trades under this strategy.

This is why we should cut our losses short and allow our profitable trades to ride.  The mathematics of trading are simple:

1.  The market is essentially random (most of the time)
2.  You must protect capital by tightly controlling risk because your attempt to predict randomness will fail (most of the time)
3.  You must allow the times that you are correct to more than pay for the times that you are incorrect
4.  Repeat this formula through time

The application is simple - set stop-losses and don't cap your profit potential.

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