One of the old sayings in trading is “let your profits run” and “cut your losses.” This maxim has apparent roots going back as long as 150 years, and applies to all kinds of trading and in all markets.
The basic idea behind this particular saying is to encourage traders to get out of losing positions quickly, but have the patience to stay in winning trades and resist the tendency to sell winning positions early. Assuming the trader follows a sound trading strategy that has an edge over time, following this rule allows profits to accumulate over time, while drawdowns are kept at a minimum – resulting in a much more enjoyable trading experience.
A large portion of sticking to this rule has to do with managing human emotions, which we will address later on in this post. First, let’s have a closer look at this saying by breaking it into two parts:
Cut your losses
Cutting losses is important because it allows for a fresh start. It is also a part of money management, which is crucial for successful long-term trading. Remember that there are countless examples of traders who unexpectedly got wiped out because they did not adhere to this rule, when market conditions suddenly changed.
By cutting losses, traders are also able to manage the risks carried by each individual trade. It is also good practice to automate this process by using stop-loss orders that automatically gets executed when price hits your pre-defined stop level.
Let your profits run
Most traders tend to sell a winning position early because they are afraid of the possibility that their profits will evaporate. They also tend to hold on to losing positions for a longer time in hopes for a rebound. This is largely a result of human emotions at play, and you therefore need to control your emotions to become a truly profitable trader.
Most people are optimistic by nature, and they therefore tend to think that it is better to hold onto a losing position in hopes that it will turn around than to realize the loss. However, holding onto losing positions is a horrible strategy over the long-term, and will without a doubt lead to financial ruin for you in your trading career.
On the other hand, traders who stay true to the saying “cut your losses, let your profits run,” generally end up successful. So how exactly can you be sure to implement this golden rule in your own trading? Here are a few tips to help you stay on track:
Keep the faith
As mentioned, most traders close trades prematurely because they are afraid of losing what they have already won. They play it too safe, and end up not reaping the profits that they should have.
It is important to have faith in your own trading strategy and technical analysis skills, and not give in to fear. If you predict that prices will be increasing steadily until a certain point, try it once – and wait until that certain price level has been reached before closing the trade. If it doesn’t happen, try a few more times and see what happens. Maybe there might be something wrong with your trading strategy, or that the market you are trading in is not really suited to your trading strategy.
It’s okay to be wrong
Many surveys have shown that traders with the wrong mindset often end up making losses. They think that they are right most of the time, looking for strategies that yield at least 70% accuracy. But expert traders have said that this is the wrong approach because it is impossible to be right most of the time when markets can be unpredictable, and with trends that are extremely fast-changing.
An example is the great Peter Brandt, a successful trader featured in the book ‘Market Wizards’ by Jack Schwager. In the book, he said that he assumes he will be wrong about 65% of the time when making trading decisions.
That is a remarkable statement from someone who trades for a living, but the truth is that many other professional traders share a similar win rate. It is not how often you win that matters most, but how much you win once you hit that winning trade.
In order to profit from trading, what’s important is the average profit from all the trades you make. But the thing is, it’s difficult to control how much your average profit will be. Your average loss, however, can be controlled by you with the use of stop-loss levels and good risk management techniques like the ones we teach here at Learn to Trade.
Once the average profit is known from a particular trading strategy, average stop levels can be adjusted accordingly to make sure that the losses cut will be covered by the larger average profit amount
Ultimately, it’s important to keep in mind that the outcome of one trade doesn’t really matter. It’s the average of all trades performed during a particular time period that matters, because trading is continuous and long term game based on probabilities and statistics rather than luck and gut feel.