This post will shortly cover loss aversion, and I will discuss 6 problems that traders bring upon themselves when they avoid taking a loss, and 6 suggestions to overcome the this loss aversion bias.
Let’s dive into the causes and implications of not cutting your losses.
One of the most common errors that traders make—an error that leads them to decimate their account—is not cutting their losses short. The main reason for traders to avoid cutting their losses is loss aversion.
Loss aversion refers to people’s tendency to prefer avoiding losses than acquiring equivalent gains. In other words when people lose something, it feels worse than gaining the same thing. It is said that the pain of losing something is 2.5 times stronger than the pleasure of gaining the same thing.
Below is a loss aversion value graph of perceived value of gain or loss vs. strict numerical value of gain or loss. Note that a loss of $0.05 is perceived as a much greater loss than of a comparable gain of $0.05.
The loss aversion bias causes many traders to avoid closing losing trades and taking the loss. However, by letting your losing trades run, you are making things worse, and here’s why:
6 Problems That Are Caused By Loss Aversion
- Missing out on other opportunities
- Ingraining negative behavior patterns
- Putting your account in danger
- Failing to keep a track record
- Building up stress
- Impairing your judgment
1. Missing out on other opportunities
You remain concentrated on the losing trade, missing out on other opportunities. When you keep your loss running (obviously, without any defined stop loss to close your trade), you keep tracking the trade, concentrating on every move. When the market moves against you, you feel the pain and frustration; when the market moves in your favor, you feel relieved, hoping the market will bail you out at break even.
Concentrating on your losing trades makes you miss out on all of the other great opportunities out there, while you’re staring at the charts—moving between hope and despair—tick in and tick out.
2. Ingraining negative behavior patterns
You are enhancing negative behavior patterns in your brain. You are making it harder and harder for yourself to make progress towards being a consistently profitable trader. When you let your losses run, you do so in the hopes that the market will turn around and make your trade profitable again.
When this happens, the reward system in your brain kicks in. This system is responsible for motivation and desire for a reward. The more you repeat this behavior, the more developed the neural pathways will be, keeping you longer in this vicious cycle.
3. Putting your account in danger
You’re putting your account in danger of losing much more than you can bear, potentially erasing the hard earned gains of previous trades. You’re probably familiar with the common trading account balance pattern, in which there are small gains over a long time, and then one or few big losses that, in the best case, take back all of the hard-earned gains, and in the worst case, decimate your account.
4. Failing to keep a track record
You’re missing out on the opportunity to test your system and methodology and see if they really work. If you don’t work according to an organized trading plan, with a defined exit strategy and risk management, you cannot really look back and say what worked and what didn’t work. Without analyzing your trades, looking at the statistics, and understanding what works and what doesn’t work for you, you cannot become a consistently profitable trader. You’re just a gambler.
5. Building up stress
You are getting stressed, nervous, upset, impatient, and unable to concentrate on other tasks. Eventually you close your trade at a much bigger loss than planned, when losing one more dollar is more painful than admitting you’re wrong. As the losses pile up, you are less functional and probably much less social, taking all your anger and frustration on your family and friends.
As you can see, not only do your losses wreak havoc in your trading account, they also hurt your relationship with your loved ones. Is letting your losing trades run—simply because you didn’t define your stop at the entry—really worth ruining your personal life?
6. Impairing your judgment
If you’re leaving your trades open overnight—or just staring at the screen for hours, watching your losses grow bigger—you’ll end up depriving yourself of good sleep, proper nutrition, and physical activity. Stress is a slow, silent killer, but your judgment on the following days will suffer much faster, making things much worse for you.
A Short Example Of Loss Aversion
In the screenshot below, taken from USO commentary on Investing.com, you can see the approach of 2 traders: the one framed in red continues averaging down, insisting he would not sell:
I bought at 3.8, 3.3, 2.8, 2.7, 2.5, 2.35, not going to sell!!
The one framed in blue has come to the realization that it is time to take the loss:
I got long at 2.97 and it is time to take the loss and learn a lesson. …
6 Suggested Solutions To Overcome Loss Aversion:
- Define your risk before entering the trade
- Think of the risk in terms of units rather than money
- Think of losses as a business expense
- Approach each trade with a fresh mind
- Trade on a series-of-trades basis
- Enjoy the process of trading
1. Define your risk before entering the trade
Define your risk ahead of the trade. Before entering any trade define exactly how much you are willing to risk, and set your stop loss and position size accordingly. Remember to set the risk so that you will feel comfortable with every losing trade, and a losing streak will not risk your account.
2. Think of the risk in terms of units rather than money
Think of the risk in terms of units rather than money. One unit of risk will be defined as 1R. Each trade you take will have its stop loss and take profit defined in units of R. For example every stop loss will be 1R and every take profit will be 1.5R.
3. Think of losses as a business expense
Think of trading as your business, in which losses are simply expenses. Just like restaurants throw expired food away, and factories need to replace old machinery, you also have business expenses in the form of commissions and occasional losses. These losses are incurred expenses that you have to absorb when you open a trade to see if your opinion about what the direction of the market is correct. That’s all it is.
4. Approach each trade with a fresh mind
Leave your ego aside, and approach each trade with a fresh mind. Don’t try to get even with the market after a loss, and don’t carry any hard emotions from previous losses into your present trades. Each trade is unique and independent, and previous wins or losses have nothing to do with the way this trade will work out for you.
5. Trade on a series-of-trades basis
Trade on a series-of-trades basis, rather than on a trade-by-trade basis. This means that once you trust your edge, you need to examine it over a series of trades, and not expect THIS TRADE to work. If your edge gives you 6 out of 10 trades, you have to take all 10 trades, but you cannot know which of the trades will be the winners (6/10) and which will be the losers (4/10). Therefore, you must not give too much significance to any particular trade.
6. Enjoy the process of trading
Enjoy the process of trading rather than looking at the outcome. As long as you keep thinking of how much money you’ll make or lose on each trade, you will never make real progress. Just like an author focuses on writing the story rather than on the number of books she’ll sell, so should you focus on the story the market is telling you while you’re in a position. The outcome will appear once the story ends and your position has been closed in a profit or a loss. Enjoy the story while your position is open.
To summarize, letting your losses run is a bad habit that makes things worse for you, and keeps you away from your dream to trade for a living or just become a consistently profitable trader. The good news is that you can overcome this habit by truly understanding what stands behind it, and what you can lose when you’re in denial of the problem. Follow the 6 pieces of advice above to take control of your trading and the positive results will follow.
If you want to become a professional trader, a consistently profitable trader, you have to fully accept the loss. Only by understanding that every loss is part of the business, and that you cannot gain without losing, will you be able to turn your trading around and start trading like the pros.