The concept of money management and the psychology of money management is the most important overlooked factor of successful trading. So in this unit, we will study one of the most important components of the psychology of money management. That is the willingness and ability to take losses. Not only will be understand why traders can’t take losses, but we will also understand more about why traders hold on to their positions for too long.
I won’t dive too deeply into the psychology textbooks here, but let’s look at some basics. Humans, in general, grow up learning the importance of always being right. In fact, those who are right are envied in society as winners. Those who are wrong are often cast aside as the losers of society. There is this constant fear of being wrong, in case we are rejected. However, the need to always be right is going to hold you back as a trader.
So carrying on from that, we learn that having a profitable trade means you’re a success. We learn that this success makes us a winner because we were right. On the other hand, we learn that being wrong means we are a loser and failure. Therefore we learn that an unprofitable trade means we are failures at trading. Sound familiar?
So with this in mind let’s take a look at two systems. Assume that you have read every article on the website. You spent months following my analysis, using my signals and you ask for a trading system to use. I say “take your pick between these two”. Which one would you choose?
Which System would you choose?
Hands up to those who said, system 2?
It’s a much better system, isn’t it? Because there are more winners. You have not needed to take many losses, certainly not as many as the other system. A clear choice right?
Wrong! You don’t have enough information to say to sure.
For example, I appreciate that system 1 has more losers than system 2, but how big are system 1’s losers? The loss on system 1 could have lost everything in the account and now the trader is broke. And how big are the winners with system 2 anyway? So you need to know how much is at stake with each system. Because let’s say system 1 risks 20 points on the DAX to gain 200 points, a 10:1 reward to risk ratio.
Let’s go into more detail and start with System 1. Let’s say you are trading at €5 per point. With the system, using this sample of data, you have 2 winners for 200 points each = 400 points = €2000. You have 8 losers for 20 points each = 160 points = €800. Based on this example you are €1200 up (2000-800). But you only have a 20% win rate in terms of winning vs losing trades.
On the other hand, with System 2, let’s say it is a high percentage win rate system, with a large stop loss and a small profit target. Let’s assume each winner gains 35 points but each loser is 500 points. We have 9 winners and 1 loser. We won 315 points (9 x 35) and we lost 500 points (1 x 500), so we are 185 points down, despite winning 90% of the trades. €-925.
So that was a long-winded way of emphasising that a high win rate, does not mean you will gain more profit. Because one loser can wipe out your gains, in fact, one loser can wipe out your entire account. So you should be comfortable to compare the win rate of a system, with the reward to risk ratio that the system uses.
System 1 has a reward to risk ratio of 10:1, so for every 11 trades, it needs to win 1. That’s a 9% required win rate. The sample achieved a 20% win rate. It’s profitable. Despite having to take losses
System 2 has a reward to risk ratio of 35:500 (or 7:100), which is strange. But it means for every 107 trades, we need to win 100. That’s a 93% required win rate. The sample achieved a 90%. It’s not profitable.
But most people will still look at system 2 as the more favourable option because it shows more winners. Traders are scared to take losses because they believe that it makes them a loser.
A trader may take the system home and begin trading it on the first day and quickly get a trade that goes off for a profit of 35 points. So you think great profitable trade, it’s a winner and then a couple more days go by and a more winners, you become comfortable. You realise it’s a brilliant system, so you increase your lot size. Then day 20 comes and here’s the loser. You start getting 50 points into drawdown, then 100, then 150, but you think, it’ll be ok. A couple hundred more points later and your equity is low, you can’t take any new trades because of your margin. Then the stop loss is hit and all the gains are gone and there’s a dent in your account.
So whenever you are trying to decide whether a system is profitable, understand the statistics. Don’t make your conclusion on the win rate alone. You have to factor in the reward to risk ratio as well. Be comfortable calculating the break-even win rate. You do this by working out how many winners are needed from your reward to risk ratio:
|Reward: Risk||Winners Needed||Breakeven Win Rate|
|1:5||5 out of 6||(5/6)x100 = 84%|
|1:1||1 out of 2||(1/2)x100 = 50%|
|2:1||1 out of 3||(1/3)x100 = 33%|
|3.5:1||1 out of 4.5
2 out of 9
|(1/4.5)x100 = 22%|
So long as your system or strategy win rate is above this breakeven number, it is profitable. There is a disclaimer at this stage, let me explain. These calculations are on the assumption that the system or strategy is a set and forget system or strategy. What I mean by that is the take profit and stop loss levels are always set using the same ratio relative to each other. And that the trades are not closed early, but are left to run until it’s closed by hitting one of the two levels. Traders have a tendency to not follow this rule making the calculation skewed.
Having a basic understanding of this calculation will help you understand whether your system or strategy is profitable. It will also help you understand that it doesn’t necessarily matter how many losers you have, providing the numbers are correct.