Tuesday, January 21, 2020

The Right Way to Lose in Trading

The recent Forbes article is one of the better ones I've written, describing how we can best deal with major setbacks in life.  There are few better arenas for learning to deal with loss than trading, because trading is by its very nature a probabilistic game.  Losses are normal and expectable, even for the best traders.  Your win percentage can be 60% and you will still have better than 6% odds of three consecutive losses.  That may not seem very high until you calculate how many trades active traders might place in a year's time.  For that active trader, losing streaks are guaranteed.

Of course, the issue is more complicated than that because market conditions change and our win rate itself has a degree of variability.  That 60% trader may go for stretches of time winning 75% of the time and stretches of 45%.  This further ensures the presence of winning and losing streaks that are guaranteed even with the best processes and psychology.

So a major challenge in trading is learning to lose the right way.  If we change how we trade after every random loss, we will become incoherent in our approach to markets.  If we fail to recognize when we are trading poorly, we can turn expectable setbacks into prolonged slumps.  If we become overconfident after every random winning streak and underconfident after every normal losing period, we'll be sized largest when things turn for the worse and smallest when we're ready to rebound.

So what is the right way to lose in trading?

The right way means that we make a hard distinction between making money and trading well.  Trading well means that we understand what we do when we're successful and that we follow those best practices, including the best practices that allow us to adapt to changing market conditions.  The goal is to be consistent in trading well, not focused on the random ups and downs of daily P/L.  If we lose money and trade well, there may be a message in that about a changing market.  If we lose money and trade poorly, there is probably a message in that to take actions that align us with our best selves.  But, like the surgeon and like the baseball pitcher, we focus on doing the right things and let the probabilities play themselves out.  It's when we lose for the wrong reasons that losses can become fuel for making us better.  

All of this highlights the importance of detailed and intellectually honest review practices.  The trader that does not review and learn from performance is not a trader who is growing.  I consistently find that the traders who show the most longevity in the business are the ones who are always learning, always losing for the right reasons.  Anything less is a deathblow to our potential.  And that's the greatest loss of all.

Further Reading: