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Many traders spend considerable time figuring out when and how to enter the market, but put far less effort into determining exits and the amount of capital to risk on their trades. The hitting of your stop losses is triggering a sense of regret. That, in turn, produces a stream of thoughts regarding all the wonderful things that could have been done with the money lost. Such a pattern raises the distinct possibility for me that your stops and/or your position sizes are too extreme for your personal risk tolerance.
Personality studies among traders have failed to unearth a single set of traits that is associated with trading success. We do know, however, that personality is an important determinant in one’s risk tolerance. As a whole, people who are extroverted and who have a high need for variety and stimulation tend to be greater risk takers than those who are introverted and who desire greater routine and stability.
Many times traders don’t know themselves well and set risk parameters for their trading that are not appropriate for their personalities. As a result, normal trading events, such as being stopped out of a trade, produce abnormal emotional upheaval, interfering with subsequent decision making.
This is especially true when traders are undercapitalized relative to the position sizes they are trading and the amount they are risking on each trade.
The risk in a trade is a function of several factors:
- Position sizing – Placing large bets on trades leads to significant volatility in one’s profit/loss statement, and this can contribute to emotional volatility. In many markets, news events and the actions of large traders can move prices many ticks or even points in a short period of time, creating outsized losses when stops are missed (due to the market gapping and not trading at the stop price).
One trader I worked with recently had sizable bids comfortably below the market prior to the release of an economic report. The market’s violent reaction to the news filled the trader’s position, and prices proceeded to move against the trader. That single loss wiped out months of previous profits.
- Stops – It is common for traders to enter large position sizes relative to their account sizes and then hope to balance the risk by entering tight stops. The problem with this strategy is that simple, random price action ensures that the stops will be hit on many occasions, leading to death by a thousand cuts. The opposite problem, placing overly wide stops or not utilizing stops at all, creates the situation you mention in which a small number of losing trades eat up your capital.
One statistic I make sure my traders keep is the average size of their winning and losing trades. It is very, very difficult for traders to make money over time if their losing trades tend to be larger than their winners. Wide or non-existent stops ensure that large losers will eventually swamp a portfolio.
- Holding Period – The longer one holds a trade, the greater the expectable price variation. Prices move more in a day than an hour, and they move more in a week than a day. Extending your holding period is equivalent to increasing your position size, creating more exposure to adverse price movements. When traders hold onto losing trades, they create a double risk exposure, as they widen their time frames precisely at those times when they’re trading their worst.
If one’s trading method calls for a longer holding period (measured in days rather than minutes or hours), stops will need to be wider, given the expectable degree of normal, random price fluctuation. This means that position sizing becomes critical to risk management. The risk of a daytrade of hundreds of shares and the risk of a long-term trade of only 100 shares may be equivalent.
It is vitally important to think of the hitting of stops as normal market events. Your stop is your way of knowing that the idea behind your trade was wrong. Because we are fallible and markets are uncertain, we will be wrong frequently. Many great traders lose on more trades than they win. Because their wins are larger than their losses, however, they make good livings. Stops are their friends, keeping them out of those large losers that eat up many days of profit.
As I’ve mentioned elsewhere, even a trader who is right 60% of the time and wrong on 40% of occasions will have runs of three losses 6% of the time—many times a year for active traders. If stops are too wide (or are disregarded), these normal, expectable runs of losses create what is called risk of ruin. Because all traders are subject to risk of ruin, keeping position sizes aligned with holding periods and stops is essential to success. If you’re trading large relative to your account size and you’re worrying about stops being hit, maybe you should worry.
About the author
Brett N. Steenbarger, Ph.D. is Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University. Dr. Steenbarger is an active trader and author of The Psychology of Trading (Wiley, 2002). He writes feature columns for the MSN Money website (www.moneycentral.com) and several trading publications, including Stocks Futures and Options Magazine (www.sfomag.com). |
