Three Trading Psychology Tips to Better Handle Losses
Recently, I was asked by a trader if there was a medication available to help to keep the trader?s mood up after a loss. This trader takes losses hard; he was looking for a way to not feel so bad when the inevitable losses occurred.
This is not the first time I?ve been asked this. As both a psychologist and a trader, I hear it more than others might. Often, the trader says it as a joke, Hey, if only there was a pill ?. Yeah, if only there was a pill. I know that behind the supposed levity there is a serious request there, How can I feel good in the face of a loss? or, maybe more to the point, how can I not feel so terrible when I lose money in trading?
Medication is not a Solution
First of all, recognize that medication isn?t the answer. Although I do not prescribe medications (psychiatrists prescribe meds; psychologists do not), I am generally familiar with most of the classes of psychotropic drugs. Medications certainly can be very helpful for persons with severe psychiatric aliments. They can often make the difference in helping individuals with significant psychiatric challenges be able to function within the everyday world. For the rest of us, it?s not so clear-cut.
Effectiveness of Medications Challenged
The efficacy of some widely prescribed medications is currently under serious question. For example, now that the clinical trial data for some of the newer antidepressant drugs are available to researchers, the data are being reanalyzed and looked at more closely. Some well-executed studies are finding that the clinical effect of these medications may be no better than placebo (sugar pill) for all but the most severely depressed. Here is a link to one report BBC News Health and a link to the journal article reporting the research Journal Research.
I am not surprised by these findings. When I was doing a lot of clinical work in the 1990s, I often heard psychiatrists I worked with complain that the new antidepressants worked well for a while, then pooped out (their term) and it was a common problem. Patients responded well for a while, but then returned to their base-line level of depression and it may simply have been that the placebo effect had worn off. At the time, some of the psychiatrists tried switching medications, usually with the same result a brief period of improvement and then a regression. Some psychiatrists actually added a medication to potentiate (i.e., amplify) the original antidepressant they essentially prescribed a second drug to help make the primary medication work!
Given all the adverse side effects possible with some of these medications (just listen to the litany of side effects described on any of the television commercials promoting an antidepressant), you want to be aware of the risks associated with any psychotropic drug. It is also helpful to know that in many cases including severe psychopathology, psychotherapy (talk therapy) is as effective as medication and, unlike medication, has an enduring effect. Even when medication works well, once the patient stops taking it, the problems return. Not so with psychotherapy.
Three Tips to Better Handle Losses
It is very unlikely that a medication is going to help you feel better about a trading loss. There is no simple fix to the emotional problem of losses. No one likes to lose money, and a loss can be very painful. But, being able to take losses is also a part of the trader?s job description. One of our tasks as traders is to take losses as a routine function of the trading role.
To help make losses more of a routine event rather than an event that throws us into emotional turmoil, here are three key tips to help you better handle losses:
1. Have a trading edge. Define your setups well and be sure they have an edge. By an edge I mean that these setups have a certain probability of winning over a large number of trades. In other words, based on your experience or historical testing, your trade setup should possess a positive expectancy that over, say, 100 trades some percentage (e.g., 67%) will be winners and produce a sufficient profit over loss to make the trade worthwhile. If you don?t have a trading edge, you are likely trading random patterns and you are likely to have many, many losses.
2. Know the probabilities of your edge and think in terms of these probabilities. No trade setup works 100 percent of the time. If, for example, your edge has a 67% win rate, then you know that it also has a 33% loss rate. One out of every three trades is expected to be a loser. Knowing this gives you some psychological cover. When you do have a loss, it isn?t the ?end of the world? for you. It is simply an expected outcome of your edge.
3. Keep your risk well within levels you can tolerate. Keep in mind that psychologically, we amplify the experience of a loss. Numerous studies show that we tend to psychologically experience a loss at about 2.5 times the magnitude of a win of a similar size. In other words, if we have a winning trade of $1,000, we feel good. If we lose $1,000, however, it feels like we?ve lost $2,500. It is important, therefore, to limit risk to not only to what your account size can bare, but also what your personal psychology can handle.
If you keep your risk at reasonable levels both in terms of your account size and your psychological tolerance, then a loss is not experienced as painful. For your account size, a good rule of thumb is to keep your risk level to between 1% and 2% of your account equity for any given trade. For your psychological tolerance, you have to set your loss amount at a level that you can live with. This level is different for everyone and may very well be less than the 1-2% rule of thumb.
Trading is a demanding game to master. Part of that game is to be able to handle the psychological experience of losses. This doesn?t come in the form of a pill. Dedication, hard work, developing edges, thinking in terms of probabilities, and managing both the financial and the psychological sides of risk are some of the more important components related to handling the inevitable losses and mastering the game.
Gary can be contacted through his website at Trading Psychology Edge