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When you trade for a living the single greatest danger is to allow one single idea to ruin your account. History is replete with single trade blow ups from LTCM which refused to unwind its massive bets on bond spreads to the London Whale who managed to turn a hedge on rates into a colossal loss for JP Morgan.
The dynamic of all these trades is depressingly similar. A trade is put on. The market reacts in the exact opposite manner of the original thesis and instead of letting go and starting over, the trader is holds on, lowers the stop and often adds to the losing trade increasing his risk.
All of this occurs because of the very common psychological trap called the sunk cost bias. Once we are committed to an idea, an action, a trade we find it very difficult to let go. There is of course a fine line between sunk cost bias and perseverance. In fact the bias is simply a byproduct of our survival skills. Where would we be as a species if we gave up every time we faced an obstacle?
For those of us raised on the good old fashioned Anglo-Saxon values of “die before you quit”, the sunk cost bias is an especially vexing problem when it comes to trading. And frankly I don’t think we should try to fight it or change our values to avoid it. Perseverance is one of the most admirable of human traits and we shouldn’t jeopardise it in order to circumvent the sunk cost bias.
Instead I think its much better to the minimize its impact by thinking of trading as an art best practiced in tens. Instead of focusing on just one trade, make a conscious effort to evaluate your performance in batches of ten trades. This will help to diminish the importance of an one trade that you are doing, will put your actions in proper perspective and will eliminate the notion of sunk costs as you will start to focus on the process rather than the trade.
Why ten? No special reason. But ten is a big enough number that will allow you to take losses with minimal emotional involvement and will also provide a crude but effective sampling methodology. If you strategy is supposed to be 70% accurate and instead it only produced 3 winners and 7 losers then you may need to reconsider what you are doing. It may simply be a bad batch of trades but if the numbers don’t improve in the next ten trades than you should certainly pay very close attention to what happens next.
As human beings we will never fully eliminate the sunk cost bias from our behavior, but by trading in tens we naturally expand our field of vision and don’t fall victim to the one catastrophic trade that kills our account.