How To Cut Your Losing Trades
Cut your losses short, let your winners run. While this piece of advice is well known, you will find that the majority of retail traders do not put this into practice.
Instead, they hope that losses will turn into profits and cut winning trades because they fear that the market will turn against them. This type of behavior is often because of a traders psychological pitfalls.
In this article, we won’t be addressing the mental side of the coin, but rather will focus on the practices and techniques that you can use to limit losses. By having an executable framework, most of the psychological errors with regard to cutting losses can be mitigated.
Side note – Read 4 Ways To Deal With The 4-Letter L-Word In Trading to prevent losses from affecting your performance.
Don’t forget to learn about this process’s other aspect by reading How To Let Your Winning Trades Run.
Remember that losing is inevitable. Our goal as traders is to lose less when we are wrong, let us look at techniques to achieve this.
1. Use a stop loss order
A stop loss (SL) is an order placed by a trader to close a position at a defined price. Stop losses are used to limit losses on a trade.
All a trader has to do is analyze the point at which their bias is no longer correct, and set the stop loss at that point.
Stop loss on a chart
In the example, the stop loss was set above the resistance zone because if price had to break through, the basis of the trade would be invalid.
Stop losses are the simplest way to cut losing positions. The benefits of using these orders are immense, including:
- Trades are closed automatically (you don’t have to lose sleep at night or sit in front of your computer for hours)
- Adds an element of objectivity which prevents your emotions from ruling the decision-making process.
- It helps a trader determine their position size on each trade (using the difference between entry and SL level).
- Certain brokers, such as Plus500, offer guaranteed stop losses, which allows you to set the maximum amount you are willing to lose (protecting against gaps).
- Setting these orders is very simple on most platforms – All it takes is dragging and dropping or typing in the relevant exit price.
- Stop orders are not set in stone, they can be adjusted to break even or trailed to lock in profits.
SL’s are the first tool you should focus on when limiting the harm of unfavorable trades. Study the most effective placement of the SL (dependant on your approach) and adjust until you find the sweet spot.
2. Have a set of exit rules
Most traders have entry rules, but you will be surprised that many don’t bother setting exit criteria. If you are guilty of this, remember it is pointless to hold a trade when the probabilities are no longer in your favor.
Start by analyzing all of your losing trades, and you will notice ways in which you can close these positions earlier for a smaller loss. For example:
- The market may close above or below a critical zone without hitting a stop loss. In this case, you can close the position as soon as a candlestick closes past the support or resistance zone.
- Breakouts through trendlines can indicate a shift in momentum, thus you can cut losing trades if this occurs.
- Large engulfing candlesticks in the opposite direction to your bias can be used as a sign to exit.
- Fundamental or news events can be used to cut losses if the momentum is likely to continue against you.
Each technique to close losing trades should be written down and form part of an exit strategy. These criteria must be executed with rigorous discipline just as entry rules would be.
Don’t enter if you don’t know how you will exit!
3. Don't risk too much
You should never allow yourself to risk more than your limit. Losing capital in this manner is inexcusable.
Remember, trades that you lose too much on were destined to be losers anyway. So risking extra capital on these positions will never help your bottom line.
Furthermore, us traders find it hard to manage trades correctly when they are too big. Judgment is clouded because the result can significantly improve or hurt your trading capital.
For example, it is psychologically challenging to press the close button if an exit rule is met because you have to accept a larger loss.
If you are guilty of this, STOP! By fixing this one error, your results will automatically improve. Keep your risk per trade and leverage manageable!
4. Don't overtrade
Having more open positions does not equal more profits. In fact, the result is extra stress and poor trade management. You should be trading in such a way that you feel comfortable and have enough time to make sound decisions.
But what does this have to do with cutting losses? Well, by overtrading, you could miss exit signals because there are too many positions on your plate.
So don’t be too trigger happy while trading because managing your open positions is more important than trying to catch every market move.
5. Remember the consequences of poor trading
Refusing to cut losses when required is terrible trading. Cutting out actions that don’t help our trading results may seem difficult, except if you remember how your own errors have hurt your profitability.
Remembering bad trading is very simple… Keep a trading journal with information on the trades you have taken, the situational factors at play, your emotions, and the trade result.
When reviewing your journal, you will come across all the times you should have cut trades for a smaller loss, but you didn’t, and how much this ended up costing you. The next time you have to cut a loss, think of this and you will press close in a heartbeat.
6. Ask yourself questions
When traders ask me, “what are some ways I can stay objective while trading?” once suggestion I will give is “by asking questions.” Here are some questions you can ask while managing your positions to determine if it’s time to exit:
- Do the probabilities favor my bias?
- Would I enter again?
- Are there any technical signals against my trade?
- Are there any fundamental or news items against my trade?
The answers to these questions do not necessarily mean you have to exit, e.g. if there is a break of a trendline but you do not use them, this doesn’t mean you must close your trade. Yet questions like these prevent irrational thinking and aid good trade management.
7. Have a trading system and stick to it
While this isn’t a way to decrease the size of losing trades, it does prevent the needless loss of your trading capital.
If you are trading the Forex market without a strategy, I suggest you stop and take the time to put one together. Without a strategy, you cannot learn from losses because the trades placed are based on random decisions made under different circumstances.
By having a strategy, you inevitably cut out unnecessary losing trades where the probabilities are not in your favor. Once you know you have an edge and execute it, all losses are a part of the game, which brings me to my next point.
You should be trading your edge, and that is all! Never take positions outside of your framework. Losses that stem from breaking your methodology are unacceptable.
A good trade isn’t a winning trade… You should always view a good trade as one where you executed your strategy well.
A bad trade isn’t a losing trade.. A bad trade occurs when you break your system rules or take a position that is not in your framework.
Trust me, if you have a system and follow it, you will be surprised at how many losing trades are avoided through disciplined. Just by having reasons to exit, you will find it easier to remain objective when managing positions.
Reasons why cutting losses is so important
- Taking smaller losses allows a trader to stay confident in themselves and their trading strategy.
- Ensures a better risk to reward ratio.
- Dealing with losses psychologically becomes effortless.
- You will lose less money when market conditions are not in your favor i.e. you can survive until your strategy thrives.
- Your equity curve will be smoother, which is excellent in the long term if you want to raise money from investors.
There is no reason to hold and hope in trading. Rather cut your losing positions when the market tells you its time and move onto the next opportunity.
By trimming down on your negative trades size, you will notice your performance and profitability climb in the long run.
Never forget that our objective as traders isn’t to avoid losses. It is to lose as little as possible when we are wrong.
Cut losses, let winners run!
Cutting Losses FAQ
Closing out a position as soon as the probabilities are no longer in your favor based on your exit rules.
Cutting losing trades allows us to decrease the value of our losing trades and improve risk to reward.
Use a stop loss, have a set of exit rules, and constantly question if your reasons for entry are still relevant.