Learn Why Traders are Overdependent on Wins and Losses

January 04, 2017 13:00

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Dear Traders,

Many traders are tempted to see profitable trades as 'good' and losing trades as 'bad'. But is the equation that simple?

In theory, could the difference between losing or winning one tenth (0.1) of a pip really deserve such a stark distinction?

Today's focus is to critically examine what constitutes a 'good' or 'bad' trade – and the result may not be what you expected. This article will review what determines the 'success' of a trade and discuss key factors such as trading psychology, win versus loss size and the trading plan.

Feel free to join the debate by posting your comments, questions and views in the comment section below.

trade forex and cfd

Trader's psychology with wins and losses

Most traders find it difficult to accept losses, even small ones that really do not hurt your trading account and capital.

From a psychological point of view, accepting losses is twice as painful as the gains made by winning trades. It is, therefore, not surprising that traders will try their best to avoid a loss, even though this could harm their results in the long-run.

Why?

The goal to avoid losing trades at all costs, unfortunately, does bring a high cost with it. In many cases, traders are not even be able to accept a (very) small loss because in their mind each loss equals failure.

This particular mindset changes a trader's behaviour substantially because they:

  1. hang on to their losing trades too long
  2. close their winning traders too soon.

The success to long-term profitable trading is the exact opposite – let your winners run and cut your losses short (see trade management video).

In my view, a losing trade is not automatically a bad trade and a winning trade is not necessarily a good trade.

But which factors should be considered critical?

Essence of good and bad trades explained

First of all, it is vital to focus on the long-term rather than just one trade. Always keep in mind that a series of trades provides way more information on both a trader and a system than any win or loss.

Secondly, it is not wise to take ad hoc decisions during the development of a live setup if such a change is not mentioned in your trading plan. These decisions are often taken because traders think they can outsmart and beat the market movements.

In reality, most of these trades are based on the psychological of trading – such as fear, hope, and greed – that occur during an individual setup.

How can traders remove this bias?

In my view, there are 3 key factors:

  1. being prepared from a trading psychology point of view
  2. focusing on a healthy win ratio and loss ratio
  3. following one's trading plan.

Trading psychology: how to beat the market

The first step is to become consciously aware of the biases mentioned above – overlooking the importance of long-term results and our temptation to outsmart the market.

Being aware of our weaknesses allows us, Forex and CFD traders, to spot behaviour and ideas that are directing our trading decisions towards irrational choices and conclusions.

It is important to actively keep reminding ourselves of this bias when trading. Only via diligent awareness and prevention can traders move beyond this thinking bias and keep their minds clear and focused on target.

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The real measurement: follow the trading plan

The next improvement step is by following the plan rather than attempting to 'beat' the market and price action at each twist and turn. Traders will never be able to pinpoint and forecast every single price action and reaction.

The main characteristic of a good trade is when traders in fact follow their trading plan regardless whether the individual trade ends up as a win or loss.

The main characteristic of a bad trade is when traders break their trading plan even if their trade ends up as a win.

By following a trading plan for a while ( at least 40 trades), traders are able to measure whether the trading plan is profitable (or not) in the long run. Long-term consistency is actually the best way for traders to beat the market.

What happens if a trader continuously interferes with a system's trading plan? In that case, traders can never know what is really causing the losses – the trading plan or their own interventions.

Let's use an oversimplified plan as an example.

Your trading plan stipulates to use trend and Fibonacci for analysis and entries and MT4 Supreme Edition and VPS (volatility protection settings) for trade management purposes. Simply said, failing to follow the stipulated plan is in itself a 'bad' trade, whereas following it is a 'good' trade because it allows traders to become consistent in their long-term approach.

MT4 Supreme Edition + Volatility Protection

Win and loss ratio

Last but not least, keep in mind that losing a trade for 1 pip is really not the same as a 100 pip loss. With proper risk management rules applied, a 1-pip loss should really have no larger impact on the trading capital.

In fact, the most important element of a loss is the loss ratio and not the absolute number of pips. For instance, a 30 pip loss is small compared to a 150 pip stop-loss size. The loss is in fact only 20% of the original risk. However, a 20 pip loss with a 25 pip stop-loss for an 80% loss ratio has more impact on the account than the previous example (even though in the 1st case the pip loss is higher).

The same holds true for the win ratio. A 100 pip win might seem great but not if the stop-loss is 300 pips (win ratio of 0.33). The same result, however, improves significantly (by a factor of 6) if the stop-loss size is 50 pips (win ratio of 2).

All in all, traders are better off by focusing on the win and loss ratio rather than absolute gains or losses. The win versus loss ratio is also known as the reward to risk ratio (R:R ratio).

If you'd like to learn more, please check out our dedicated section on technical analysis. It's being constantly added to, so you'll always have access to the most practical, up-to-date information.

You can also join our Zero to Hero course, where we not only demonstrate a clear trading system but also discuss how traders can understand price patterns and the larger market structure.

Cheers and safe trading,

Chris

Zero to Hero Trading Course