Playing the game

On the inevitability of losses

In this article I face up to the inevitability of risk, and so the inevitability of losses. Just trading a market forces a speculator to deal with risk, and so manage losses. The way he does this makes the difference to his trading account. So I consider the different possible scenarios with regard to losses:

One of the most dangerous trades for a speculator is a trade that initially shows a profit, but later swings to a loss. With the idea that the market can show a profit at all, a trader can get suckered into a nerve wracking situation of increasing running losses as a volatile market reverses. A good example is a trade I made on the GBP/USD, after quite a bit of appreciation, but with indications for further dollar weakness: Losses scenario

It seems to me that it is far easier to close a trade that only ever showed a loss because the trader is not used to ever seeing any profit for his efforts. He can take the view that he was on the wrong side of the market to begin with and cut the loss as usual, then seek some other opportunity to get the right view on.

It is a market that induces a trader into thinking he has the right view and makes him first expect a profit but then catches him out that is difficult to deal with. It is hard enough to get into a winning trade in the first place, so how does a speculator deal with losses on a trade that was previously winning? Why is situation so dangerous to him? The most desirable course of action is to cut losses as usual, paying the insurance premium against worse losses, and missing on any profits despite the previous indication that a win could be in store. Some time later the market may present a good opportunity to rejoin the winning side or play the other. That is fine. The difficulty is to get suckered into an alternative that seems more attractive than cutting losses - to risk that little bit more on the original trade - hoping that a more favourable chance to either cut losses or take profits will occur. The trouble with more risk than usual is that it changes a trader's perceptions. It then becomes even harder to cut losses, but actually easier to allocate more and more risk to a trade, eventually to the point of either a painfully hard loss, or 'risking everything' to sit the trade out with as large a loss as can be taken to get results. A speculator can face practically unlimited liability. So on the occasion where the market does not bounce back, a trading account is going to go broke if this situation occurs. Occasionally the market will reverse and recoup losses - after all, markets are volatile - but not every time. I am also sure there are a myriad of other unknown situations where trading accounts can go broke if defence is not in mind!

Another tricky course of action that sometimes seems more attractive than cutting losses is adding to a losing position, or cost averaging. If the speculator had been able to take his original losses without changing his risk profile, like he probably ought to, then this kind of activity could never occur. It would only be a simple matter of rejoining a market with the same view as before, and paying the usual insurance premium, but at an apparently more favourable level. The danger with cost averaging is that the speculator further enhance his wrong view, suckered into taking on yet more risk, focussing on the ending rather than the beginning of a trade. It is important to begin trades rightly, and not under the wrong circumstances.

So we have hit on the argument that losses are about risk, and the facts of the matter are that anyone who trades on any market has to manage risk, and so manage losses. For careful traders losses mostly occur in small amounts, but considering that the mistakes for speculation are numberless, even experienced investors can be suckered into losses once in a while. Why does this happen? Boredom? Ill discipline? The thing to remember is that many others will also have been caught out by exactly the same market action. Previously profitable trades for them will now either be showing a loss or showing a much reduced profit, and traders will be adjusting limits accordingly. The traders on the other side of these will have new positions that are immediately showing a profit for the opposing direction, and so will be either targeting profit levels or positioning their stops for protection in case the original trend resumes.

With a market in new or untested territory and a lack of indication as to pivotal price levels, trades that originally show a profit and then show a loss create an interesting and potentially volatile scenario. Traders on the one side can either be taking losses and leaving the market, or staying in and hoping for the original trend, or changing direction. Traders on the other side will be still wary of the original trend, but experimenting with tests to see whether the tide has turned. Which side will win? The tide turns when buyers become sellers or vice versa. If enough work together in the same direction for enough time it will trigger the stops of the losing side, exacerbating volatility, but then eventually either hit the winning side's profit targets or reverse and hit their stops. In the uncharted territory of new highs or lows, some may be hoping the trend will continue and others fearing the trend will reverse, with others fearing the trend will continue and some hoping the trend will reverse. The risks are that we don't know the majority until the market shows us what has happened. All the more reason to exercise strict loss management techniques and not get suckered into bearing unecessary risk! To email me your comments, please get in touch