August 1, 2015

How Do You Keep Losses Small?

It’s one of the most important aspects to trading. Actually if you take care of losses and keep them small, then the profits take care of themselves. Most people don’t realise that.

The Pips Predator works out a zone around which the odds are in favour of a move in a certain direction. It then suggests the most opportune time to enter. It does this based on indicators and mathematical algorithms based on years of observation of hard historic data.

But that does not mean the price may not move against you first. It is not a time machine which travels into the future, but rather something which says ‘there is now a 70% chance of a move into a trend based on historic observations of the same price behaviour’.

So what do you do if the price moves against you? Some people just wait and wait. In fact most private investors do that. But they do it out of fear of taking a loss. They are wrong to wait. Professionals get out quick, at a small loss, and then re-enter if warranted.

The reason professionals do this is because they know a small loss is a lot better than a big one. They know to protect their profits is the most important thing. They know they can get back in. That is an optimal strategy. It is better than a strategy of wait and pray.

So sometimes you may see the Pips Predator show an entry signal, and then the price go in the opposite direction (by a lot). That doesn’t bother us – we are already out by our own principles. If the price moves back beyond the entry, then we get back in.

What if you dont want to sit in front of the computer? That’s simple, you just do a stop loss where you say exit if price drops 2xATR (see later post on this). You can also add a limit order (take profit) which could be 3xATR.

Now of course by not being in front of the computer you are missing adding additional positions if the trade moves in your favour, but you add those orders at say each time the price moves to make you a 1% profit. Of course now you are adding more orders and that takes time.

Remember time=money. If you are not in front of the computer, that is fine, but it will cost something.

  1. Yes it can be frustrating that some trades don’t win.
  2. The key is to keep those losses small
  3. The key is also to get trades which move in our favour
  4. you see small stakes are the price we pay for a seat at the table. Of those we hope expect a number will be small losses, and not work out, some will be small gains, and about 1 in 5 will be big gains. – I will do a slide on this. This is the case with even the top funds.

The most important thing is that while we wait for the 1 in 5 big wins, we keep the losses small on the others, and the small wins pay for those. You see 80% our profits come from 20% of our wins.

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Are Indicators Supposed to Always Win?

The markets are often volatile and change direction sharply. Ideally an indicator would of course see everything in the future with 100% accuracy. There are annoying market flip flops.

  1. We want of course all our trades to be winning trades, and big winning trades.
  1. But even in the best hedge funds, 80% of your profits will come from 20% of your trades. You would want to have all your trades of course to be big winning trades. But they are not. Only 20% will be big winning trades, where you get in, there is a smooth upward trend, you can add to wins and make even more profits.
  1. So what about all the other trades? The other 80% of trades? Well about 40% of them will be small wins – they will never become big wins, because the market will turn. What looked like a good trade, the market turns and makes it a small profit.
  1. And about 40% will be losses. Now the key is to make sure those losses are small.

Remember you also have two rules for keeping losses small:

  1. The three period exit
  2. The 2xATR method ie when you enter, set a 2xATR stop loss and 2xATR limit order

Ie keep those losses small.

How should you feel about losses?

  1. Happy they are small
  2. Happy you followed your process
  3. Happy you freed up capital for future trades

What if you want to increase your wins? Just don’t have a stop loss. BUT that won’t help your profits of course. And that is why we have stop losses, to ultimately protect our profits.