In our last lesson we introduced the concept that money management in trading and the psychology of money management as the most overlooked but most important component of trading success. In today’s lesson we will begin to look at one of the most important components of the psychology of money management: a willingness to be wrong.
Humans in general grow up being taught by their environment of the importance of always being right. Those who are right are envied as the winners in society and those who are wrong are cast aside as losers. A fear of being wrong and the need to always be right will hold you back in general, but will be deadly in your trading.
How Most People Associate Profitable Trades:
How Most People Associate Unprofitable Trades:
With this in mind lets say that you have been watching my trading video lessons and feel that I am an intelligent trader, so you want me to give you a forex trading strategy. I say fine and give you a method and tell you that the method will trade 100 times a year with an average profit of 100 points for winning trades and an average loss of 20 points for loosing trades. You say great and take the trading strategy home to give it a try.
A few days later the first trade comes and quickly hits its profit target of 80 points. Great you say and call a bunch of your friends to tell them about the great system you’ve found. Then a few days later the next trade comes but quickly takes a loss. You hold tight however and then the next trade comes, and the next trade etc until the trade has hit 5 losers in a row and amounting to 100 points in loses on the losers so you are now down 20 points overall, and all your trader buddy’s who started following the system after the first trade are now down 100 points.
Now you feel really dumb and are the joke among the group of guys that you trade with, so the next day you come back to me yelling about how bad the system I gave you is. I say ok and tell you I have another system for you. This one also trades 100 times a year but has a higher success rate that I think he will be happy with. You take this system home and the next day it quickly hits a winner followed by another then another and then another until over the next few days you have 5 winners in a row totaling 50 points in gains for your account. Getting very excited you call all of your trader friends and tell them that this time you have found it, you tell your wife how you haven’t lost on a trade in two weeks and you rub your perfect trading statement in the face of all your trader buds as revenge.
So now ask yourself this question. If you were really the trader in this example which system would you rather have?
I can tell you from experience that the large majority of traders will take the second system without a second thought, and on top of that will stick with it even if it hits a few losses that wipe out most or all of its gains.
Although the successful trader will want to know a lot more about both these systems which we are going to learn about in the lessons that come before deciding which one to trade I can tell you that what they will glean from the above information is the following:
Not including transaction costs such as commissions and slippage, for the first system I only need to be right 1 time for every 5 times that I am wrong in order to break even. With this in mind seeing the system trade for one profit and 5 losses is not giving the system a chance to prove itself. It would not be out of the ordinary for a system such as this to hit even 10 losers in a row and still end up profitable for the year.
As I did not give the trader success rates for the second system there is no way to know for sure but the first suspicions that the successful trader is going to have of the second system is that it is simply a system which sets tight profit targets and very wide or no stops at all. What this means is that the system is going to take a lot of small winners and a very few large losses which have the potential to wipe out all the gains in the account and possibly a lot more.
Most of the successful systems that I have seen fall into the category of the first one we looked at in that they take a lot of small losses and make their gains for the year on a few big winners. As in this example however most traders do not have the mental toughness to stay with these types of systems during the long loosing streaks and give up on them prematurely, and throwing a profitable methodology in the trash without giving it a chance.
This concludes this lesson. You should now have a good understanding of the affect that losses have on ones decisions in trading and can begin to prepare yourself for the losses which are going to inevitably come with any trading methodology whether good or bad. In tomorrow’s lesson we are going to look at two common trading mistakes that often knock traders out of the market.
