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Learn To Lose

If I were to offer you a choice of two different trading systems with the following qualities, which would you prefer? Ignore differences of account volatility – it’s not germane to the main point I wish to make.

System 1 has a win rate of 40% and returns 40% annually.

System 2 has an 80% win rate and returns 30% annually.

Logically, it’s a no-brainer. System 1 is superior. However, struggling traders always prefer a system with a high win rate. The reason for this is not hard to imagine. Winning feels good. Losing is painful. We all desire to maximize the time we feel good and minimize the time we feel pain. Designing a system with an 80% win rate is not very difficult. Here’s one such system to trade the ES:

  1. Use your favorite indicator or collection of indicators to define entry conditions. This will produce a nice set of random entries with no inherent edge.
  2. Exit the position at 1 point profit. Use a 4 point stop.

 

That’s it. Over time, you will have 80% winners and a 0% return overall – actually less than 0 when you account for commissions and slippage. The winners will be plentiful, the losers relatively rare. But the losers are doozies and will wipe out the profits from a nice run of winners. If only we could make the losers even more rare. Well, we can. What if we add to the trade when the position goes against us by 2 points and use a 1 point target so that we can scratch the entire trade at break-even? This would halve our losers, but now when they occur they would be even more painful. Ugh. Maybe, we could add 2 more contracts if our position goes down 3 points from initial entry? Now, we can scratch the trade at breakeven if we take a 1 point profit from this new level, halving our losing trades yet again. Now our losers will be even rarer but devastatingly painful. If you have struggled at trading, you might recognize this thought process – I have already had this brainwave myself. You know this thinking doesn’t end well. Adding to losing positions just makes the pain even more acute when we lose so we enter a vicious cycle as we try to eradicate the necessity to realize losing trades.

The problem with the above system is twofold: the first is that the system never had an edge in the first place. The high proportion of winning trades just gives us the false impression that we do have an edge. The second problem is that our actions exacerbate the problem we try to cure: our aversion to taking a loss.

We all evolve as traders. The Martingale-based strategy above is usually one of our first attempts to avoid the pain of losing.   After blowing up an account by adding to losers, we tend to become a bit more sophisticated in blowing up our second account. Our focus though remains the same: maximize winners and minimize losers in keeping with our psychological imperatives to maximize pleasurable experiences and avoid painful experiences.

So, how do we blow up account number two? Slowly. Death by a thousand cuts. Our focus now is to use the experience of the losing trades to ascertain what factors were involved with the losers so that we can filter out losing trades before we make them. If you have more than a very few variables that you look at to trigger trades and to evaluate trades in progress, there’s a very high probability that this is the phase you’re in right now. You continually tweak your entries, stops, targets, add an indicator here and there and become more and more overwhelmed by what your growing collection of indicators is telling you. You become twitchy and nervous while in a trade, scratching trades for no good reason that you can discern after you close them. All the time, you beat yourself up for making what you later determine to be errors to be avoided in future. I’ve been there. I do feel your pain.

The way out of this is actually quite simple and doesn’t involve you paying someone to discover some childhood trauma that is the root cause of your losses. All you need to do is change your focus. Don’t try to make winning trades. Just focus on executing a strategy that you believe has a long-term edge. If you are correct and you actually have a winning strategy, profits just happen as a natural by-product. Of course, this sounds much simpler than it is in practice, but it starts by accepting that we cannot predict what will happen in any particular trade.

If we accept that trading is inherently a probabilistic rather than a predictive endeavor, then we don’t get emotionally attached to being right – nor do we become emotionally distraught when we have losing trades. If we cultivate the mindset of a blackjack or poker player, we are on the right lines. Imagine that our system simply identifies the dealer’s upcard and that we only trade when that card is a 6. In this case, we have a long-term edge and would happily take every trade. Alternatively, if you play poker, imagine you have the nut flush draw on the flop and your opponent goes all-in. The pot is offering you 4 to 1. You call every time because your chances of hitting the flush with two cards to come are just over 2 to 1. In both examples, you are simply playing the probabilities rather than predicting the outcome. Note that, in the poker example, you expect to lose most of the time: don’t focus obsessively on win rate.

So, first things first: get a strategy that has an edge. I can tell you that Auction Profile will provide such an edge, but you should be skeptical. I am trying to sell it after all, so it’s not likely that I would claim that it’s useless. All I ask is that you apply the same skepticism to whatever methodology you are using now or are considering using.

Ask these questions of any methodology you are evaluating.

  1. Is it logical? Is it based on sound principles that you believe to be true?
  2. How many variables does it use? The fewer the better. Be especially skeptical of methods that employ a welter of indicators and variables or that claim you need thousands of hours of screen time to completely master.
  3. Is it able to be mechanically employed? Can entries, exits and targets be unambiguously specified? Can you write down a trading plan that allows for no discretion after the entry? If not, how can you consistently apply the method?

 

I have tried to make Auction Profile as logical and mechanical as possible while still allowing discretion in its use. As you can see from the charts on the website, Auction Profile uses a small number of variables and it should be easy to create a trading plan that gives clear signals.

Regardless of your interest in Auction Profile, try not to become obsessed with a high win rate and don’t try to predict what will happen at the hard right edge of the chart. Focus on trading a method with an overall positive expectancy, not on the outcome of any one trade. Losers are inevitable. Don’t fear them and don’t try to avoid them.

 

 

 

 

 

 

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