The good loss

Posted by Scriptaty | 1:05 AM

How can any loss be “good,” you ask? A good loss is the result of taking the right position given the information available at the time. You weighed the information — fundamental, technical, or both and believed you had a realistic expectation of a profit. You took the position, but the fates intervened and threw a fresh piece of information into the market, or a new participant with different ideas. Your position turned into a loser, and your risk management rules forced you to exit with a loss. Next case.

Notice how many assumptions about the trading business are embedded in the preceding sentences. First, you gathered a lot of information to make the trading decision.

It doesn’t matter whether the decision was largely or even entirely informed by technical indicators. Technical indicators distill market sentiment, and are as valid a decision tool as any other. In fact, most forex market observers believe about 90 percent of all forex traders use technical analysis in some form.

Second, if you had a realistic expectation of profit, you had an idea of the probable scope of the upcoming move — in other words, a profit target. This is an important difference between professionals and amateurs: Professionals know where they plan to exit a trade, whereas most amateurs do not. Moreover, amateurs kick themselves for exiting a trade too early, no matter how stupendous their gain. If the price continued to move further, they mourn the lost opportunity. Professionals make note of this, but they don’t get emotional about it.

To evaluate a trade, however, you need more than the profit expectation. You also need to know the potential loss. Let’s say you can realistically expect to make $1,000 on the trade. Are you willing to lose $3,000 to make $1,000? No. You would soon be out of the trading business if your trades had that risk-reward profile.

If you want to keep losses smaller than gains, your stop-loss exit point has to be a smaller distance away from the entry point than the expected profit- taking level. If you expect to make $1,000, your stop has to deliver a loss of less than $1,000. Traders would love to get a 3:1 or higher reward-risk ratio, meaning a $3 gain for every $1 loss. In practice, they are sometimes lucky to get 1.5:1.

Professionals with losing trades already know how big the loss will be — say $350 in the case here and therefore it hurts less when they have to take it. The loss is not a surprise and it’s also not a disaster.

Professional traders are always ready to move on to the next case. Losses are a natural part of trading. Everyone takes losses. Anyone who can’t take losses either doesn’t have enough capital to be trading in the first place, or lacks the psychological makeup to be a trader. Professionals can ride out losses both financially and psychologically; they are confident about their trading abilities even as they contemplate taking a loss, and even after they take it.