One of the most important rules of trading is “cut your losses short and let your profits run”. Following this rule alone goes a long way in ensuring trading success. But then what makes novice traders deviate from this rule?
No prize for guessing! Yes it’s the human emotions. We are taught to be optimistic from childhood with sayings like “it’s darkest before the dawn” etc. Which though useful in other areas of life, can prove to be fatal in trading. Persevering and not accepting loss in sports, battles or other ventures may ultimately bring success but in trading if we continue with a losing position or worse double our effort/money it'll wipe the account sooner than later. When a novice is in a losing position he'll find himself to be full of optimism and try to convince himself that the position will return to profits very soon even if the losses are getting bigger and bigger.
The opposite of it is also true i.e. when he is in a winning position, he becomes pessimistic. Now teachings like “greed is bad”, “a bird in hand is better than two in the bush” starts to haunt his mind. He become overly eager to book whatever little profits he has in his hands.
So what’s the remedy? Actually from the very beginning a trader must have a system for trade/money management which has clear rules/guidelines for booking loss and trailing profits. The trader will feel confident in his system if the system has been back tested for being profitable. Another point is that emotions play bigger roles in positions where the size is bigger than the trader’s risk taking abilities.
Therefore if one doesn’t want to be optimistic or pessimistic at the wrong time he should have a system for managing positions and should not make a bet that he/she can’t afford to lose.
Post contributed by Jitender Yadav