How to leave the party gracefully
I admit it … I’ve been there … staying too long at a party … overdoing it … waking up the next morning wishing I hadn’t had that last drink … who’s idea was it to end the night with flaming sambuca, anyway? (Oh, it was mine.)
It’s human nature … when times are good, we believe they’ll stay good forever – in fact, we believe they can just keep getting better.
Who’d have taken the human race for such a bunch of optimists?
Unfortunately, this sunny optimism gets us into a whole lot of trouble.
Not just on nights out … it’s what keeps us in winning trades too long … and gets us overstaking after a winning run …
Here’s scenario 1 …
I’ve just started live trading a new strategy … I’m using small stakes, and my first three trades have been winners. Fantastic! This strategy just doesn’t lose.
Trade number four comes in as a winner too. That’s it, I’m going to invest more money in this. Tomorrow I’ll double my stakes. (Can you see where this is going?)
And scenario 2 …
Our trade has gone into profit … we’re watching the positive figures clock up on our spread-bet account … do we take those profits off the table? Or would that be snatching them too soon? Should we wait until we’ve eeked a bit more profit out of the market?
The result of both these scenarios is – too often – a headlong plunge from profitability into losing territory.
What we want is to be the person who walks away from the table with money still in his pocket … the one who leaves the party before things get messy …
How do you decide on your stakes? Rationally or emotionally?
Where we went wrong in the first scenario is more obvious … we haven’t stuck with our plan, we’ve got excited and overstretched ourselves with our staking, and failed to take into account that a winning run can’t last forever.
Keep consistent with your stakes, and build your fund slowly through compounding.
The words I tell myself as I place each trade is … this could be my longest losing run yet … Sure, it’s not very optimistic, but it keeps me from getting too ballsy when I’m heady from a winning run.
Just as we have to keep our cool with losing trades – we also have to keep calm when we’re winning.
The second scenario is a bit more complicated.
Do you get jittery about taking a profit?
We’re often told by ‘trading gurus’ to hold our nerve … not snatch at winners … aim for a 2:1 risk profile (i.e. expect to make two times what we’ve risked on a trade).
So, following this wisdom, if I’ve risked £100 on a trade, I mustn’t accept a profit on it below £200.
I’ve ranted at length in Trader’s Bulletin about risk reward ratios, so you’ll know too well how I feel about traders insisting on 2:1 returns …
While it would sound like a good ambition to increase our profit targets from 40 points to 80 points, it’s actually incredibly hard to achieve. You’re trying to capture more of an instrument’s daily range, requiring more precision in your entry, and possibly an unrealistic idea of how far that instrument actually moves in the timeframe.
If you want to improve your profits, it’s a more realistic ambition to try to hit your targets more often. (If you’re not hitting them often enough, then making your profit target larger seems unrealistic anyway.)
That’s why it’s significantly easier to improve your success rate by 5% than to boost your risk-reward ratio from 1:1 to 1.5:1
The message I’m trying to give is that we shouldn’t be too greedy with our risk-reward ratios.
But what we should do is monitor both our ratios and our success rate, keeping an eye on profitability. The best traders I know are the ones who take, take, take profits off the table with a high degree of success.
Look to improve your success rate – if you can just win one extra trade in 20, you’ll have a boost of 5%. And it’s only if you’re consistently winning that you should consider pushing your profit targets.
And if you’d like to experience a system that’s been taking, taking, taking profits (with an accuracy of around 75%) … you can sign up for DIFF CODE here. (NB: the early-bird offer closes at midnight on Friday 1st August 2014)
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2 comments
Mark Rose
Hi Paul, I’ve not seen this before but sounds interesting – would be good to find out more about how it works in practice.
Paul H
An interesting approach I have recently come across is to set a1 to 1 risk reward ratio for the initial position size. This position size is then increased by 50% when price reaches half way to the target; or decreased by 50% of original position size if price moves half way towards the stop loss. The main advantage of the 1 to 1 risk reward ratio is that price has a 50% probability of hitting the target, whereas with 1.5 or 2 to 1 ratios, the probability diminishes significantly below 50% i.e. the odds are against you, with fewer winners versus losers which can be stressful. Has anybody come across or tried this approach ?