Tricks of the Trade Part 2 – Learning to Lose

To trade well you must learn to lose. That may sound like unusual advice from a guy who throws more temper tantrums than a teething baby any time a trade doesn’t go his way, but it is nevertheless the most fundamental truth of this business. Trading at its core is the art of managing failure.

Of course that is not how most retail traders approach this game. Subconsciously we expect to win every time we open a position and several losses in a row often send us into a near catatonic state of despair. I’ve often suspected that the reason most people quit trading has less to do with their ability to read the market and much more to do with the psychological shock of losing money on a near daily basis. After all, there are very few areas of life where we confront failure every single day.

Generally in our daily routine we are almost always preconditioned for success. We expect the trains to run on time, our computers and Internet connections to work flawlessly, our clothes to be perfectly pressed when pick them up for the dry cleaners and a million other mundane tasks that we take for granted. Indeed, the purpose of our civilization is to constantly engineer failure out of existence by providing us with better tools to handle all of natures many challenges.

Even in highly complex and risky professions such as emergency medicine we have become much more proficient at our tasks. ER doctors face a multitude of medical problems, most of which they are able to control. In an industrialized country, it is almost unheard of for an emergency doctor to lose a patient every single day, unless there are some special circumstances such as an unknown virus. On the other hand if you are trading FX, a losing trade every day is the rule rather than the exception.

I make this analogy not to trivialize medicine which is a far nobler and greatly more valuable calling than speculation, but rather to a make a point about expectations. The reason trading is so difficult is because it stands outside our normal frame of reference. As modern day human beings we are just not used to dealing with constant failure as a way of life. Most traders will accept one or two losses in a row, but few realize that even in a 80% accurate strategy they can often generate a string of five or six consecutive stopouts.

There is no perfect way to combat this problem but a trick of the trade that I’ve found useful is to simply run your strategy manually on a price chart to see how well it performs during random periods of time. Many traders of course back test their strategies and many computer programs offer very sophisticated analytical tools to show you how the trades have performed. However, while computer backtesting is a nice tool, it is virtually useless in helping you trade. Reams of computer driven reports can provide you with an academic analysis of your trading methodology, but none of them will offer you the psychological truth that comes from actually feeling the trades as they occur on the chart. There is something incredibly powerful about marking your wins and losses by hand that makes you absorb the dynamics of your strategy in the most primal and effective way. We may be highly evolved mammals, but we are mammals nonetheless and as such we are still tactile animals. I’ve found that by just working out my strategy on a chart, seeing all those wins and losses cluster and spread out over various time frames, I was able to trade much better in real time because I knew the likely outcomes and was not as perturbed by a string of stopouts. After adjusting my expectations I finally learned how lose.

Boris Schlossberg

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