Thursday, 14 August 2014

How to Handle Trading Losses

Last time we discussed how to handle trading losses. We focused on how to control your emotions when you lose money. Once you can do this, what happens next? Suppose you've made a string of trading losses. You are feeling calm and collected, and are ready to do something about it. What should you do?

There are two options here.
Option 1: You can do nothing, and carry on with the same trading strategy you already use.
Option 2: You can stop trading and come up with a new strategy before starting again.

Depending on the situation, either of the options may be suitable. When deciding what you do, you need to first analyze your losses. The key question you need to answer is this: Are my losses consistent with my trading strategy?

What do I mean by this? Suppose you have backtested your trading strategy and are implementing it live. If you analyze the backtest results, you should get a good idea of what the losses look like. For example, if you have a strategy that trades daily or less frequently, you should expect to have some months where you lose money.

From your backtest results, you should also get an idea of the magnitude of potential losses. The next step is to compare your actual losses with your backtest results. Then you can ask whether your losses are consistent with your trading strategy.

If your losses are consistent with your strategy, the best thing to do is carry on executing your trading strategy. Assuming your trading strategy is a good one, you should return to profitability soon.

What happens if the losses are not consistent with the strategy? What happens if you are losing a lot more money than you expect to? Now things change. At this point, you should consider going back to the drawing board.

It is likely that the trading strategy no longer works as well as it should. At this point, it is time to come up with a new trading strategy.

Here's a little secret about all trading strategies: At some point, every strategy stops working. Why is this? Market conditions change over time, and market patterns do as well. So at some point the strategy that you are using will become obsolete.

When you encounter trading losses, you need to evaluate whether your strategy has become obsolete. And if so, you need a new strategy.

What many traders (myself included) do is have a pipeline of different strategies. Even while I'm trading a strategy now, I'm simultaneously working on developing new strategies. That way, if my current strategy stops working, I can replace it with another one.

To be a successful trader, you need to be always researching new strategies. You never know when market conditions change, and you need to be ready for when they do.

Handling trading losses consists of the following steps:

Keep your emotions in check and ensure that you are making rational decisions.
Evaluate whether your losses are consistent with your trading strategy.
If they are consistent, then carry on implementing your strategy as normal.
If they are not consistent, then you need to change your strategy before trading again.

If you follow these 4 steps, you'll learn to handle trading losses correctly. And this will ensure that you are profitable over the long term.

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