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Avoiding Losses – Part 1

F T L
2 minute read

Let’s take a minute to examine two situations.

Scenario 1:

You take a look at the chart for S&P futures closely for awhile, and decide to open a 3 contract long position. The price goes up 6 ticks in price as you predicted and you happily see your position close from your limit order . This trade was only 20 minutes, for a nice little profit of 18 ticks, or $225. You feel great that you were correct and because of the profit.

Scenario 2:

You study the chart for S&P futures and open a 3 contract long position in the same way as Situation 1. The price goes down, 6 ticks against you. You watch as your stop loss triggers, and proceed to feel awful about losing $225 in 20 minutes.

So what is the difference between these two scenarios? The profit in the first is equal to the loss in the next. You might say that the first trade is as good as the second was bad. This makes sense intuitively.

Now to change the comparison, imagine at the start of Scenario 2 you use your analysis and instincts to avoid entering the trade at the last second. What is the difference now? You have gained $225 in S1 and avoided losing $225 in S2. These are equivalent results in terms of dollars. Nevertheless, the profit is treated more fondly. There is a trick of the mind at play; the human brain notices patterns better in action rather than inaction.

To ramp up the comparison further, now assume that this is the first trade of the day. Winning on your first trade feels good with a chance to make you overconfident, causing you to lose out on trades later. Compare that to starting out by avoiding a bad trade. You might not even check what would have happened to the trade, and will probably remain in a relatively healthy neutral mindset. If you had of carried out the bad trade, that would be much worse than being overconfident or neutral. Starting out with a bad trade can completely ruin that day if it tilts your emotions.

The point here is that when you save yourself from a bad trade, it can be even more beneficial than winning a trade of the same amount. This is because it saves you the mental and emotional headaches that often lead to your worst trades.

Alright, now that we’re all clear that avoiding bad trades is great, what do we do about it?

 

There are a two main goals you should keep in mind to keep the amount you lose in trades small. Next week we’ll cover those.

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