Most of us were conditioned in our upbringing to associate failure with punishment and fear. Your teacher reprimanded you for doing poorly on a test. Our parents yelled at us for getting bad grades in school. Sports coaches fumed when you made a mistake that hurt the team. Most of us became conditioned to punish ourselves internally for mistakes, and continue to do so for most of our adult life.
Losing Is Inevitable In Trading
In trading, this self-punishment is very destructive. Losing trades are unavoidable, even if you are a seasoned, profitable veteran who has been trading for 10 years. Some of the best traders have a win percentage under 50%, meaning they have more losing trades than winning ones. There is no strategy that has a 100% win rate. We talked yesterday about why 95% of traders fail. But what allows winning traders to be profitable traders is their risk management.
Most new traders don’t realize that losing trades are not necessarily bad trades. One losing trade or losing day does not mean you are failed trader. Successful trading is not about avoiding losing, but learning how to lose the right way. And the only way you can lose the right way is learning proven risk management strategies to maintain a high reward vs risk ratio on your trades.
Red Trades ≠ Bad Trades
Let’s say you long 1000 shares of a stock at $20 a share on an earnings breakout setup. On this particular setup, you win about 65% of the time. Your stop loss area is at $19.50, and your target is $22. Unfortunately, your position goes against you and hits your stop loss at $19.50. For the rest of the trading day the stock tanks and closes at $15 a share.
In this scenario, you lost $500 when you stopped out of your position, but you would’ve been down $5000 if you didn’t cut your loss. This is an example of a good loss to take. This is a setup you win on most of the time, and it just happened to be one the 3/10 when it doesn’t work. If the stock had ended up being a winner, you would’ve made $2000, 4 times what you just lost.
Green Trades ≠ Good Trade
Let’s look at the same scenario a bit differently. Let’s you took the exact same trade and set up. The stock retraced to $19.50 and you didn’t take the loss, and it kept tanking to $15. You still are holding on praying that it reverses. Luckily, it reverses at $15 a share and closes at $22, your target, and you sell and make $2000.
This is an example of a bad trade that you made money on. You had a terrible risk vs reward ration on the trade, as you risked $5000 to make $2000. You would not make money on this setup in the long run with this poor risk management, even if your win ratio is at 65%. You would lose all of your money if you kept doing this. The stock could’ve kept tanking and gone to $10 the following week and you would’ve been down $10,000.
Focus On Your Process
Pro traders shift from the mindset of "Did I make money on that one trade?" to "Did I follow my trading plan that makes me money consistently in the long run?". As you can see from the example above, having a solid risk vs reward ratio is essential for consistently profitable trading. To maintain a solid risk vs reward ratio on your trades you need to have sound risk management. The better your risk management is, the less you have to worry about being right on every trade. Therefore, it is imperative to spend time learning and developing risk management techniques.
Free Webinar on Risk Management and Consistency 2/25
Because risk management is so integral to your trading success, we are doing a free webinar on 2/25 to show you our proven risk management strategies and tips for finding and maintaining consistency in your trading.