WHY DO MOST TRADERS FAIL?
If you are considering a career as a day trader, you cannot ignore the statistics that show only 1 in 10 traders will be able to make a living at it. I am not saying this to discourage you from trading. We are going to talk about the reasons why most traders fail so you can avoid making those same mistakes. I believe failure is an option, one that is often chosen without the trader realizing it. Just as failure is an option, so is success, if you make the right decisions. Most traders that I have seen fail were unable to follow simple rules of risk management. We will be discussing the rules of risk management in the next chapter, but let us first talk about the reason why it is so difficult to follow the rules. Trading becomes extremely emotional when we are faced with losses and even wins. Being a day trader puts you in the unique position of having to experience a financial loss every single day. On a good day, you will win more than you lose and end the day with a net profit. But, even on the best days there will still typically be at least a few losing trades. There is no such thing as a strategy or a trader who is 100% successful on every trade they take. The best traders may be profitable every month out of the year, but it would be unreasonable and statistically improbable to expect 100% accuracy. Even investors who make billions of dollars have losing investments. This means you will have to face loss and become comfortable with it. The traders I have known who have failed were never able to cope with loss. They allowed the fear of loss to guide their trading decisions.
The hunt for the Holy Grail
If you are a trader who is constantly jumping from strategy to strategy or technical indicator to technical indicator, you may be suffering from the Holy Grail syndrome. These traders will spend tremendous amounts of time and energy searching for the perfect combination of indicators and strategies that will always give them winning trades. On the surface, it makes sense to search for the best strategy, but that's not the motivation of these traders. Just below the surface is a deep fear of loss. It is a fear so strong that it motivates these traders to search endlessly for that perfect strategy in hopes of preventing them from having to experience any more losses. These traders sometimes work to create automated trading systems, search out other traders they can mirror trade (following trade for trade), or simply jump from strategy to strategy until they have exhausted their financial resources and give up. If you are in the group of traders hunting for the Holy Grail, I would encourage you to read this carefully: you can lose 50% of the time and still be make money just as easily as you can be right 90% of the time and still lose money. You have to focus not on your percentage of success, but on your profit loss ratios.
Profit Loss Ratios
Profit loss ratios are often overlooked by novice traders. We have our students trading with a minimum 2:1 profit loss ratio (every trade has the profit potential of 2x the risk). With a 2:1 profit loss ratio, our students can make money and be profitable with only 50% success rate. When I work with students, the first thing I look at is their trade history. I want to know their profit loss ratios and their average percentage of success. These numbers will tell me if they have a sustainable strategy. If you can trade with a 2:1 profit loss ratio, it becomes much easier for you to succeed. Most traders who fail will be trading with negative profit loss ratios. Meaning they lose more on average than they win. Regardless of their percentage of success, they will have set the bar so high, it becomes almost impossible to succeed. The odds are stacked against them. From a purely statistical standpoint, a negative profit loss ratio of 1:2 (you lose 2x what you win on average) is an unsustainable strategy unless you maintain 75% success rate. After years of trading, I can assure you that maintaining a 75% success is not easy. Often times the failed traders will exit the market having never realized they were destined for failure because they did not learn about the profit loss ratios required in order to be profitable.
Profit Loss Ratio Statistics
2:1 Profit Loss Ratio = 33% is your Break Even before commissions
1:1 Profit Loss Ratio = 50% is your Break Even before commissions
1:2 Profit Loss Ratio = 66% is your Break Even before commissions
Fear of Loss in Trading
Fear is a natural emotion, but it's difficult when your job requires you to experience fear on a regular basis. Many traders will experience fear in a number of ways. The most obvious is the fear of financial loss. We acknowledge that investing in the market and day trading in particular is high risk, but when we are faced with the decision to take a trade and expose ourselves to a potential loss, fear can begin to guide our decisions. A less obvious form of fear is the fear of missing a big move in the markets. If you suddenly see a stock start to jump up on what might appear to be breaking news, or you see a reversal begin to take shape, you may feel inclined to jump into the market out of fear of missing a potential winner. The fear has guided your decision and led you into an unplanned trade. You may have purchased at a price too far away from your stop or taken more shares than your risk tolerance allows. In a split second you made a decision and broke your rules. The result when these trades go badly will be a larger loss than your strategy and rules allow for. When I speak with a trader about a massive loss, they often say "it happened so fast." They made a quick decision and it was the wrong decision. In reviewing my own trading performance, my biggest losses were spontaneous trades I jumped into on an impulse. I see the markets starting to move and jump into a stock without fully analyzing my risk. Unfortunately, when emotions are guiding a trader's decisions, big mistakes are common. We will discuss techniques for managing emotions while trading, but first let's review a few other examples of erratic trading brought on by emotions.
Holding Losers Too Long
As you can see, our fear of loss in trading can manifest itself in some unusual and outright counterproductive ways. Many beginner traders and most failed traders will experience the tendency to hold their losers too long and sell their winners too soon. The driving emotion that leads to this behavior is a fear of loss. Why does a trader hold losers too long? It is because a trade is not a loss until you have hit the sell button. There is always the chance that the price could pop back up until you hit the sell button. The fear of making the loss real keeps you in the trade because it makes you think about finding a way to turn the trade around instead of just taking the loss and moving on to a different trade. The reality is that small losses are not a big deal, but a trader in an emotional state does not think that way. Sometimes traders will make a bad trade worse by averaging down, adding shares at a lower price to reduce their cost basis. This typically results in bigger losses when it is not part of a proven strategy that involves scaling in and out of trades by averaging. I have worked with traders who set $200 max losses, and on a trade when they were down $200, instead of simply cutting the loss, they decided to add more shares so they could trade out of the loss. These trades would often end in losses of -$1000 or more. In hindsight, it is easy to say the right thing to do was simply cut the loss at -$200 and follow the rules you made for yourself. Unfortunately, in the heat of the moment, emotions take control and your rational thought processes get thrown out the window. In those cases, the fear of loss actually resulted in the trader taking bigger losses than the rules of trading would allow for. This is the exact opposite of what you want! The most important skill for a new trader to understand and adopt is the ability to cap their losses.
Selling Winners Too Soon
If you enter a trade that had a good profit potential and it fit into your trading strategy, the last thing you want to do is sell the trade before it has had a chance to work. If you are up 10 cents on a trade that has the potential to make 50 cents, there is no reason to sell it. Why do so many traders sell their winners too soon? It is because the fear of loss has guided their decisions. It is the fear of the small winner turning into a loser that convinces us to sell the trade too soon. Just as a loser isn't real until you hit the sell button, a winner isn't real until you've hit the sell button and locked it up. In the short term we feel happy to have locked up some profit, even if only a small one, but the big picture is that you are forming a habit of capping your winners. To be a successful trader you have to cap your losers and let your winners run. You will want that occasional big winner, because those will tide you over during periods of slow trading. A trader that sells winners too soon and holds losers too long has the habits of a failing trader. To avoid failure these traders must address how their emotions are influencing their trading. Instead of selling the full position when sitting on a small profit, I combat that urge by selling a partial position and adjusting my stop. This means I will walk away with a small profit (not a loss), but still have a position in the trade to let it realize its full potential. This is called scaling out. Scaling out is a great trade management method of keeping partial positions with a good cost average. To maintain discipline, I refuse to sell my final position until I get stopped out by a valid exit indicator.
Embrace Loss as a Part of the Business
Instead trying to search for the Holy Grail, or give in to the urge to hold losers and sell winners, we must simply accept loss as part of the business of day trading. We cannot fight it. Every day trader will experience losses. Becoming a good day trader means being a good loser. The trick to being a good loser is learning to cap your losses at a set dollar amount and sticking with it. The hard part is holding yourself to the rules. Day trading requires a tremendous amount of discipline and self-control. It is a job that will challenge you in more ways than you would imagine. In the example of the trader with a 90% success rate that was still losing money, he failed to cap his losses. Being that type of trader is a choice. By teaching you about profit loss ratios and the importance of capping your loses, we are empowering you to make the choice to be a successful trader.
Discipline as a Practice
In our trading courses, we spend a great deal of time working with students to help them improve their discipline. Many of our students found us after taking other trading courses and finding themselves still stuck in a cycle of poor trading habits, trading losses, and disappointment. We realized that textbook concepts of trading, which are important and will be covered later on, are not enough. Understanding fundamental concepts of trading on their own are not enough to be a successful trader. You must also think and act like a successful trader. This means selling losers quickly and holding partial positions in your winners as long as possible. In order to help our students improve their ability to be disciplined, we require a min of 30 minutes of exercise and 15 minutes of meditation every day. I use exercise and meditation to help train my mind to cope with stress. By forcing myself to do these two things every day, I am practicing discipline. In the moment when I am in a trade and need to make a hard decision, I need to be able to fight the urge to sell the winners too soon and hold the losers too long. By practicing discipline in others areas of our life, we strengthen that muscle memory and improve our ability to maintain composure while trading. Practicing discipline is a way of conditioning our minds to become accustomed to a feeling of discomfort. Rather than taking steps to alleviate the feeling, we can train ourselves to withstand it. When we sell a winner too soon or hold a loser too long, we are allowing the uncomfortable emotion of fear to guide our decision. Most of the successful traders I know have strict exercise regimens because it helps improve their trading performance. We know it is impossible to block out the emotions such a fear, they will still surface within every trader. However, the difference between winning traders and losing traders is that winning traders will not subject their strategy to the emotion. They recognize the emotion and allow it to exist without acting on those feelings. This is a critical step in the emotional development of any trader. I would encourage you to begin journaling your emotions while trading. The first step to changing your behavior is becoming aware of your emotional patterns and their impact on your trading performance. As we discussed earlier, you can have a deep understanding of all the textbook concepts of trading, but still fail to succeed because you have not achieved the emotional training to be a trader. We focus on providing our students with a well-rounded education that includes both textbook and emotional development.
It is important to remember that discipline is not like learning to ride a bike or learning to swim. Discipline is very much like a muscle that can be strengthened when exercised or atrophy when ignored. Even after years of trading, I still find myself occasionally giving in to my instinct to chase a stock for fear of missing the move, to sell a winner too soon, or hold a loser a little too long. Every day when I trade I have to fight against my natural instincts. Unfortunately many of our natural human instincts do not encourage healthy trading patterns. If I had to guess I would say almost all successful traders have spent thousands of hours training their minds to fight against counterproductive impulses. I am sure there are some traders that have a natural aptitude for the mindset required to be profitable, but I believe the majority of us have to really work at it. It took me years to become successful, and looking back I have realized it was because of the emotional obstacles that stood in my way. I had a great concept of stocks, chart patterns, basic strategies, but I kept falling into the cycle of big losers and small winners. It took a long time before I developed the self-awareness to realize what was causing those actions. My hope is that by reading this, you will avoid the years of trial and error it took me to learn these important lessons.
One of the first things I told you was that day traders are hunters of volume and managers of risk. In this chapter we are going to discuss risk management. As an aspiring day trader, you already understand that day trading is one of the riskiest investment techniques. The reason traders choose to day trade instead of make more traditional, longer term investments is because day trading can produce much larger gains in a faster time frame. Day trading is one of the fastest ways to grow a small account, when it is done properly. The problem is most people will not trade properly. Successful traders can utilize $25k accounts to produce over $50k per year, or 200% in returns. It would not be realistic, however, for a trader to utilize a $250 million account to produce $500 million per year. The markets typically do not have the liquidity to support a trader entering or exiting a multi-million dollar position within minutes, but positions of tens of thousands or even hundreds of thousands of dollars can be executed almost immediately. This allows day traders with accounts under $1 million and as low as $25,000, to utilize leverage and high speed trading techniques to produce large percentage gains. When a trader reaches a point where they are managing more money than they can efficiently day trade, they would typically begin to branch out by adding longer term investments to diversify the portfolio.