The Beauty is : Big Profits and Small Losses
You can design a great trading strategy with profits size two times or more the size of losses, as well as you can design a great trading strategy with profits size half the size of losses. Base the distance of your stop-loss orders and the size of your profit targets on the way your market behaves and on the way your strategy tries to take advantage of it, and not on some sentence you have read somewhere on the internet or in a bestselling trading book. Though a rule might have worked for some trading superstar you admire, it might not work for you and your market that well.
You should now have a good understanding of some of the psychological difficulties people have in taking losses, and some of the different money management strategies that can be put into place to help overcome these difficulties that are the downfall of so many traders.
What may come as a surprise to many of you is that just as many traders have problems letting their profits run as they do in cutting their losses. To help illustrate this I am going to give a quote from one of my favorite books on money management strategies Trade Your Way to Financial Freedom by Dr. Van K. Tharp. When explaining this concept in his book he gives the example below:
When given a chance for “1. a sure $9000 gain or 2. a 95% chance of a $10,000 gain plus a 5% chance of no gain at all….which would you choose?”
A study which was done on this showed that 80% of the population chose the sure thing even though the second opportunity represents a $500 larger gain on average.
Similar to the way that human’s are raised in a way that does not allow them to accept losses our environment also teaches us to seize opportunities quickly, or “that a bird in the hand is worth two in the bush”, a rule that goes against the second half of the most important rule of trading:
“Cut Your Losses and Let Your Profits Run”
With this in mind we can now move into the next phase of our series of money management strategies with a look at some of the different ways that traders go about managing their position once it begins to move in their favor starting with a look at trailing stops.
Once a position has begun to move in a traders favor, many traders will implement a trailing stop which is basically a strategy for moving the stop they have implemented on their position up when they are long or down when they are short to lesson the loss or increase the amount of profit they will take should the market reverse and begin to move in the opposite direction of their position.