Wednesday, September 27, 2006

Trading to Win Vs. Trading to Not Lose

Suppose I offer you a sure $500 or the choice of flipping a coin. If the coin lands on heads, you'll get $1000. If the coin lands on tails, you'll receive nothing. Would you take the guaranteed $500, or would you flip the coin?

Most people, given the opportunity for a sure thing, will take it.

Now, however, suppose I confront you with a certain *loss* of $500. The alternative is that you can flip a coin. If it lands on heads, you lose nothing. If it lands on tails, however, you lose $1000. Would you take the guaranteed loss of $500, or would you flip the coin?

Interestingly, in that scenario, a significant number of people will flip the coin. We tend to be more risk-seeking when we deal with losses than when we are faced with gains.

Suppose we are into a trade and can take a sure point out the S&P eminis in a short-term trade. Do we "take what the market gives us"? Suppose the market moves four ticks against us. Do we hold the loss in hopes of coming back to breakeven?

There is a meaningful difference between trading to win and trading to not lose. The average person feels more psychological pain over a loss than they feel pleasure over a gain--particularly once they have already "booked" that gain mentally. If I'm expecting a bonus from my employer, I'll be happy when I receive the paycheck--but I'll be much more upset if I find out the bonus has been rescinded.

When we enter a trade, we expect to be paid out. Mentally, we book a potential profit. When a loss materializes, it is the unexpected event--and we respond more strongly to the unexpected than to the familiar.

What is the solution to this dilemma? The answer, surprisingly, is to book losses before they occur.

It's human nature to not want to think about such unpleasant things as losses. But by knowing our maximum possible loss in advance and by mentally rehearsing what we'll do on those occasions when the loss occurs, we normalize the losing process. That divests it of its emotional grip.

We can never eliminate loss from life or trading; nor can we repeal the basic uncertainties of markets. What we *can* do is develop an edge in the marketplace and, over the course of many trades, let that edge accumulate in our favor.

And, if you're trading well, maybe that losing trade will offer you a fresh perspective about how the market is trading: an insight that can make you money the next time around. Then it's not a loss. It's information that you've paid for.