For decades new studies have repeatedly shown that traders cut their winning trades too early and hold on to their trading losses for far too long.
The reasons for this behavior can be found in our evolutionary biology. Behavioral economics and cognitive psychology have demonstrated profound biases in how humans treat gains and losses, and they apply just as much to world-class traders with billion dollar positions as they do to your local Monday night poker game.
Fortunately there are ways to overcome this tendency to become attached to our trading losses, and to learn to tell the difference between a temporary setback and a losing trade.
You Can No Longer Read the Market
The one universal signal for immediately closing a losing trade is when you can no longer read the market.
Sometimes you will be set up for a trade and the price will move against you, but you knew that this was a possibility and the price action ‘makes sense’ given what you expected. In these cases waiting out a small dip before the price heads back up was an expected risk, and there is no reason that you should let a small, temporary expected loss keep you from waiting for the big gain that you were originally aiming for.
However, other times a trade will go really bad really fast, and you will have no explanation for what just happened. In these cases you should always immediately cut your trading losses, as you have obviously lost the thread of the market and you are merely guessing at what might happen next.
As long as you understand why a trade has turned against you and you have every reason to expect that this short downturn will reverse, there is no reason to panic and automatically exit a trade. However, the second that you lose sight of the goal and are cut adrift in a sea of uncertainty, it is time to cut your losses and move on to the next trade.
Perform an Emotional Inventory
Are you mad at the market and looking to get your revenge by doubling down? Are you panicking about your loss and praying it doesn’t get worse? Are you creating unrealistic fantasies that some unlikely event will come and turn your terrible loss into an amazing win?
These kinds of emotional insights allow traders to gauge whether or not they are making rational trading decisions when faced with a loss.
When faced with trading losses, take a moment to stop and analyze how you are feeling and where your train of thought is leading. If you are feeling excessively emotional, whether that emotion is fear or greed or hope or anything else, then you are no longer in the right state of mind to make rational trading decisions.
When emotions have taken over, it is time to cut your trading losses.
It can be difficult to tell the difference between a rational trading response and an emotional one, but it is something that all traders get better at with practice. Developing this capacity for critical self-reflection is one example of why it is so important to take your education and training as a trader seriously before diving into the markets with real money.
Check Your Charts
Going back to your technical analysis charts after a trade turns to losses can offer some fresh objective insight on the prospects of the trade turning back to a profit.
You may have had a strong technical case for entering a trade, but a sudden downturn can offer a fresh perspective on your interpretation of the charts that you used to develop the position. Even a small downturn can change your perspective from a high expectation of one pattern to a confirmation of an entirely different one.
Your technical analysis charts will provide you with some objective information for reevaluating your earlier decision. If the pattern still looks the same, then you can wait out the temporary trading loss until the market adjusts. However, if the pattern breaks down or a new pattern emerges, then it is time to close the trade and cut your losses.
If You Aren’t Sure, Close It
If you’ve followed all the above steps, but you are still unsure whether it is a losing trade or just a temporary setback, then close the trade.
As you develop as a trader, you will gain a sort of ‘sixth sense’ where you just know whether or not you’ve made the right decision in a trade. This is not to say that you won’t still need to work hard to develop your strategies and positions, but as you become increasingly experienced you will just start to know what a good trade feels like.
When you no longer have that feeling about a trade, then it is time to close it.
Learning to trust your trader’s instinct is an important part of become a seasoned professional. It is a good habit to develop to start letting go of the trades that you are unsure of as you grow in confidence with your good trades.
Eventually knowing when to cut your losses will become less and less of a dilemma as you learn to take stock of the situation dispassionately and automatically recognize the difference between a temporary setback and a trade gone wrong.
Experience Will Help With Cutting Your Trading Losses
These insights from top traders will help you to understand the emotions that you are experiencing when a trade goes wrong and guide you toward making the right decision.
However, the ultimate ingredients to efficient trading will always be time and experience in the end. Having a good framework of understanding based on learning from the lessons of experienced traders is essential, but these lessons can only truly be learned by experiencing live trading for yourself and taking stock of your own thoughts while you trade.
Take the time to really pay attention to your thoughts and your outcomes when trading, and you will develop the essential sixth sense of a veteran trader that allows them to succeed in the highly competitive, and lucrative, world of trading.