This post is motivated by two things: One, I have had virtually the same conversation with several of my mentees over the past month and also with a few of the other traders on the desk, and so I think I may have identified something that is affecting a lot of people. Two, I have identified this factor as the main reason I underperformed last month in my own trading, and I intend to make major corrections in this area in the coming month. Actually, I guess there is also a third reason, which that no one else seems to talk about this subject very much.
Technical traders devote most of their attention to figuring out where and when to get into the market. Most training focuses on “setups” or trade entry conditions, and, in fact, it’s not uncommon to find someone who has been trading less than a year who knows 20 legitimate ways to get into the market. Most indicators, systems, and statistical analyses (mine included) focus on defining an edge by the entry condition. If you think about this, there’s a good reason for this—it is difficult to make money if you’re not buying before the market goes up or shorting before it goes down (on average)! However, entry conditions alone do not make a trader profitable. Here is the secret that it seems no one is talking about: where you get out of the market is at least as important, and maybe more so, than where you get in. Exits are as important as entries.
There are two broad categories of exits: exits at a loss and exits for profit. For most traders, exits for losing trades are not that much of a problem. You put your stop in at your initial risk point, and, if it’s hit, you’re out of the trade. Clean and simple. I think maybe the reason that most traders are so good at this is that the market very quickly eliminates those who are not. If you’re one of those traders who likes to cancel stop orders, move them further away to give it “a little more room”, or even add to losing trades, you will probably have a short, but very interesting, trading career. Most traders who stay in the game for any length of time are pretty good at getting out of losing trades, but winning trades present a much more complicated set of problems.
There’s a weird psychological problem that hurts many more traders than we realize. For instance, let’s say you enter a long day trade in a $50 stock with a .40 stop, and you see a clear profit target a full point higher. Now, you enter the trade and it immediately ticks against you. What if it trades to .38 against you, within .02 of your stop? Few traders have an issue with this because most can accept that this may just be a losing trade, take the loss, and move on. But now imagine, having been within .02 of your stop, the stock reverses and heads higher back to the entry price—and now you’re .20 in the money where it stalls again. Now, .20 in the money on this trade is really nothing because you were risking twice that, but many traders will be tempted to take the profit here. You know this is normal fluctuation, that it may go .20 in your favor and pull back almost to the entry price before heading higher, but few traders are going to be in this trade because most of them already booked the profit. You can never go broke taking profits, as the old saying goes. The problem is, this particular old saying is bullsh*t (apologies to Penn and Teller).
There is some weird psychological process at work here. Actually, maybe it’s not that weird: it’s called “wanting to be right”. For many traders, being right is more important than making money. In that scenario I described, when you book the .05 profit, knowing that it’s nothing, some little voice in the back of your head says, “let’s just hit the bids and we can make another mark in our winning trades column.” It is possible to be very profitable with a win ratio of well under 50%, but we’re all human and we all like to be right. Be careful of focusing too much on your win ratio. (More on this in a future blog.)
Just something to think about this month and maybe it can be a growing edge for many of our readers. The nice thing about identifying a pretty glaring weakness is that it is also an opportunity, as work done here can pay off quickly in terms of your bottom line. Monitor your mental and emotional state and see how you are handling fluctuations in winning trades compared to losing trades, and make sure that you aren’t getting out of good trades just because you want to be right. (Note that there can be legitimate reasons for getting out at a small win or small loss, but what I was talking about here was when we manufacture nonsense reasons to justify getting out of perfectly good trades.)
Here’s hoping everyone has a good November!