Patience and discipline are the most rewarded skills in trading
There is no such thing as a 100 per cent accurate trading strategy. This statement alone, which is undoubtedly true, introduces the concept of losses being part of the trading activity.
As a trading mentor, I have met people who have researched different trading strategies in the pursuit of an infallible trading plan.
The result? Their chart analysis looked more like Guernica, one of late Spanish artist Pablo Picasso’s best-known works, but more confusing.
To add insult to injury, these traders were aware of the concept of risk and the need to apply an appropriate level of risk management to succeed in trading over time. But they were trying to find the holy grail that would make them infallible. Why? The truth is that our brain is wired to avoid threats and suffering, and losses are never pleasant.
On a rational level, they knew the right approach to trading but their unconscious cognitive biases were dragging them towards adopting irrational behaviours. This is where the vast majority of traders fail.
A truly sustainable trading strategy would be characterised more often than not by a number of losing trades, which can be higher than the amount of winning trades.
How is that possible? “Antifragile” systems, according to Nassim Taleb, a Lebanese-American statistician, benefit from shocks and thrive and grow when exposed to volatility.
Antifragile trading strategies are characterised by a risk-reward ratio of about 1:3 to harbour volatility and adverse market conditions over time.
This means that, on average, winning trades return three times the amount of money the trade would have lost if it turned out to be a losing one.
In this scenario, six out of 10 trades can lead to losses. But the trading strategy would have a positive return over time.
Meanwhile, the opposite of “healthy” trading strategies is the use of price averaging and martingale strategies, which would actually reverse the risk-reward ratio.
By risking four, five, six or more times the amount of money each trade would return, the winning trade ratio can rise to well above 90 per cent – and the balance line of the trading account would look like a straight line with a steep positive inclination.
Nevertheless, if we look at the equity line (balance plus open trades and profit/loss), we notice that these strategies have very deep drawdowns before finally striking a small win.
While making the trader feel like he is the next Gordon Gekko for a while, such strategies are doomed to fail and will eventually drain trading accounts to zero.
How, then, do we manage losses given the psychological pressure that characterises trading?
Trading gurus would advise you to determine the risk for each trade before it is placed by using stop-loss orders. They would also say that the possible loss for every trade should be about 2 per cent of the available capital. While such advice has merit, it is too simplistic as it does not factor in the individual risk tolerance, which might be better catered to with a lower maximum loss per trade.
Most importantly, it ignores an essential part of risk management: position sizing. The trade size should not only be calculated on individual risk tolerance, but also on placing the stop-loss at an adequate distance from the entry price.
The base of the instrument’s volatility, the presence of relevant price levels and the size of the trade also determine the calculation. By applying discipline, consistency and a well-structured trading strategy, traders will be able to produce positive returns over time and become more efficient and resilient to the different conditions they will face.
It will also reduce the psychological pressure deriving from the uncertainty that characterises trading.
It will also avoid other threats that even experienced traders can succumb to: overtrading, closing winning trades too soon and moving stop-losses to avoid a loss. The market will always provide opportunities and they should be acted upon only when they match your trading strategy and intended risk-reward ratio.
Stop-losses should never be moved in the hope of avoiding a loss as it could lead to higher losses, hinder your risk-management strategy and turn an otherwise successful strategy into a losing one.
The same rule applies to gains: be patient, wait for the price action to develop and let the winning trade run. Do this by reducing the risk at your intended take-profit level and trail the stop as long as the price continues to head your way.
Trading can be exciting and fulfilling, but being patient and disciplined is what will make you a successful trader.