You can have a good trading strategy and even get most of your trades right. But as we’ve seen, that doesn’t necessarily mean that you’ll be profitable at the end of the day.
If you’re constantly taking profits too early and worse still, letting your losses run wild, that’s a recipe for disaster when it comes to trading. We’ve all been there, myself included, in letting losses consume you and give you a false sense of hope in believing that things might turn around. It’s a slippery slope. Some of us are perhaps lucky enough to walk away with just a painful lesson. But for others, this is the thing that takes you out of the game entirely.
It all comes down to trading discipline at the end of the day.
Let’s go back to the apple store example again (I told you, I love my apples).
Imagine that you buy apples from a supplier at $10 each and hope to sell them for $15 each. That’s a potential profit of $5 per apple.
Now, business is moving along well and customers are buying apples daily. But after a few days, you get nervous that your customers might just disappear. And instead of waiting to sell at $15 the next day, you quickly sell them for $12. You still happily pocket the $2 profit, so that doesn’t sound too bad right? I mean, at least you’re making money.
But now, let’s picture the other side of the scenario. Let’s say business suddenly turns sour and nobody wants your apples, so the market price drops to $7 each. You could still sell them and take the $3 loss per apple, but you refuse. You think that surely customers will come back tomorrow and perhaps prices will recover in the days ahead. So, you decide to hold.
Unfortunately, things get worse instead. The market price drops to $4 per apple and you’re eventually forced to sell, taking a $6 loss instead.
Do you see what’s the problem here?
This is basically one of the biggest traps that traders can fall into, especially if they’re not careful or get too complacent. Yes, it can happen even to the best of us if we don’t stick to our trading discipline.
We get excited about locking in a winning trade because it feels good to be right. But when we’re wrong, suddenly there’s every reason in the world to keep holding on. And here’s a good example of how damaging that can be.
Let’s say you make six successful apple sales, earning $3 each. But then, four really bad sales cost you $6 each. The math:
- 6 profitable sales at $3 each = $18 in profits
- 4 losing sales at $6 each = $24 in losses
- Overall sales = $6 loss
Even with a 60% win rate, you’re still losing money. That’s a painful one.
Now, imagine this scenario but in trading with leverage. Without any proper stop-loss, those losses can grow far beyond what you originally intended to risk. A couple of bad trades could easily undo weeks or even months of hard work. And that is why risk management is arguably just as important as finding and acting on good trading opportunities.
Before entering a trade, you have to know how much you’re prepared to lose and where your trade idea would be proven wrong. Of course, having a stop isn’t a guarantee against bigger losses, especially when markets move sharply, but they can help to keep emotions from taking over. It may be easier said than done, but it is a crucial process to follow and get used to in order to make more logical and better trading decisions.
And perhaps most importantly, it prevents you from that feeling of wanting to move the goalposts just because you don’t want to admit you’re wrong.
No matter how long your career is as a trader, you are bound to get things wrong. And sometimes, you might even be wrong quite often. Trading isn’t perfect. But the goal is to make sure that even when you’re wrong, you can still afford to come back and trade another day.
This article was written by Justin Low at investinglive.com.