Cut Your Losses

In trading, it's not whether you win or lose, but how much you profit on a winning trade compared with how much you lose on a losing trade. If you can cut your losses and move on, you'll survive. It makes sense, logically, but psychologically, many traders have trouble cutting their losses. We hate to lose, and we will do almost anything to avoid losing, even it means denying that we've lost.

Some are happy to keep losses on paper to avoid the inevitable feelings of regret that often come with a losing trade. People are risk averse. They often sell off winners too prematurely, and keep losers too long, hoping that somehow things will turn around. But it hardly ever works. Many people would be wise to follow the advice of Paul Tudor Jones: "I spend my day trying to make myself as happy and relaxed as I can be. If I have positions going against me, I get right out. If they are going for me, I keep them." It's vital for your long-term survival that you admit that you have made a losing trade, and close it out.

Humans have a natural inclination to avoid losses, but seasoned, profitable traders cut their losses early. They work under the assumption that they might see many more losing trades than winning trades. Knowing how to take a loss in stride is a key skill that all traders must develop. It's often easier said than done. Behavioral economists have outlined many mental processes that prevent most traders from accepting a loss and moving on.

First, as humans we are naturally risk averse. We don't like taking losses.

When it comes to "a sure win," they take it immediately. But when it comes to a sure loss, they would rather take a chance, hope for no loss at all, and possibly take a larger loss than just taking the small loss up front. Both professionals and amateurs can fall prey to this tendency. Trading lore is replete with tales of traders who just couldn't take a small loss immediately. They hold on to losses rather than admit they made a big mistake. The losses continue to mount, and the hole gets deeper and deeper.

The human mind has a remarkable capacity to ignore what it doesn't want to see. And losses are hard to see. Second, a major psychological reason for holding on to a losing trade is the sunk-cost effect. The more financial and psychological costs we sink into a trade, the harder it is to take the loss and move on. It's like thinking, "I've waited so long and I've lost so much of my initial stake that I can't give up now."

There's a strong need to justify the effort and expense you have put into holding a losing position. The psychological need to justify the loss is so great that it can be difficult to write it off.

Third, social processes prevent many traders from taking a loss. It's hard for some traders to keep their wins and losses to themselves. Trading can be a lonely profession. It might be useful to join a network of friends to share experiences and get support. The downside, however, is that some people in the network may compete with you, just waiting for you to have a setback so that they can feel superior.

You may look forward to relishing your wins, but dread having to admit your losses. The need to save face can prevent some traders from taking a loss. The best antidote to this problem is to stay humble and away from chat rooms. Don't brag about your wins. If you avoid getting a swelled head, you'll be able to admit your mistakes and shortcomings more easily, and you won't worry about becoming embarrassed for losing.

Cutting your losses is vital for success, but it's hard to do. Be aware of the powerful psychological factors that prevent you from taking a loss and moving on. It may be hard to do, but if you work under the assumptions that losses are inevitable, and don't take losses personally, you'll be able to cut your losses, move on, and make huge profits.

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