Accepting the Risk, Part 1 – Stop Loss

…most traders erroneously assume that because they are engaged in the inherently risky activity of putting on and taking off trades, they are also accepting that risk. I will repeat that this assumption couldn’t be further from the truth.

Accepting the risk means accepting the consequences of your trades without emotional discomfort or fear. This means that you must learn how to think about trading and your relationship with the markets in such a way that the possibility of being wrong, losing, missing out, or leaving money on the table doesn’t cause your mental defense mechanisms to kick in and take you out of the opportunity flow.

— Mark Douglas “Trading in the Zone”

Risk and reward are closely related as we cannot have one without the other. I wrote my opinion many times before that a trade should not be judged as amount of pips or dollars that it makes. It should only be judged as the ratio between what was at risk and what was gained (could have been gained). A trade that made 100 pips but had 1000 pips SL has extremely poor 0.1 RR ratio and it is relatively easy to make such a trade and reach profit with it, just by sheer luck. A trade that made $1000 but had no SL has 0.0 RR since the was no risk limit, and we have to assume that the whole account was put at risk.

In terms of profit it does not matter whether we win 10 trades out of 10 with 0.1 RR or just 1 trade with 1 RR. If we risked $100 in each trade, in the end we’ve made $100 in each case. However, it matters a lot in terms of risk – in the first case we risked 10 times $100 to make $100 in the end, while in the second we risked $100 just once and made the same $100.

 It is interesting that most beginning traders prefer to take a smaller profit, while setting a bigger stop loss (actually, most beginners prefer not to set any stop at all, being sure that the market will go in their direction at least a tiny little bit). I think there is some interesting psychology that we can analyze here.

First of all, there is always a balance on the market. If your trading system uses 1:5 RR and you are able to win consistently more than 80% of your trades, it can still work just fine – especially if that is what your find to be psychologically comfortable. The problem here is actually going with the market flow correctly more than 80% of the time – easier said than done.

On the other hand if you take 3 times the profit compared to your risk you only need to be “right” 1 time out of 3 in order to consistently increase your balance.

Let’s think about it from a different point of view. Imagine that you trade manually and you put 100 pips stop loss trying to make 20 pips. What kind of trading opportunites are you looking for? What is the market setup where you say “The market gives signs that it will go 20 pips in my direction, but it can first retrace 100 pips against me”? Imagine the trade goes against you by 90 pips. What should the market conditions be at that moment that you still keep your trade with confidence – now you want the market to move 110 pips in your direction, having only 10 pips breathing space on the other side.

It really seems to me that trading in this way is a very dangerous psychological trap. It’s like we want our trades to be perfect, we really hate when the market goes against our positions and forces us to take a loss. But we learned that trading without loss protection is a financial suicide, so we calm ourselves by setting a huge stop loss while trying to take a tiny profit – after all, we are protecting our account, right? It really comes down to truly accepting the risk of our trading.

Accepting the risk of losing money

When a trader puts on a trade with a stop loss, he immediately assumes that he is accepting the risk that comes with that trade and that he is in control over his trading. However, we are not benefiting in any way from the risk “acceptance” that comes from the overwhelming fear of losing money.

A trader can put a stop loss, but still hope or even assume that the market will never reach it. He likes to put a bigger SL not because he is ready to take a bigger risk in his trading but because he is afraid to take any loss at all. He hopes that the bigger SL will never be hit. If there is any fear in placing the trade it means that the risk for that trade was never truly accepted.

When seeing your trade being closed in a loss causes you any emotional discomfort it is natural that you will do anything to avoid taking the loss in the first place. The smaller your stop is, the more often it will be hit. It seems that most traders prefer to increase the distance to their stop so that they do not have to experience the emotional pain that comes with losing money as often. Accordingly, bigger stop loss will possibly lead to more emotional pain when it is hit, but there is another element that I find even more important – the pain of being wrong.

Accepting the risk of being wrong

When the trade is stopped out an average trader not only feels the pain of losing money. He also perceives that the market is making him wrong, and for many traders the pain of being wrong is even stronger than that of a financial loss. I would say that even though the pain of losing money can be similar in one big loss or many small losses, the pain of being wrong on any given trade is about the same.

From this perspective we can see that for someone trading without proper mindset (someone experiencing any psychological discomfort at all about his trades) it makes sense to avoid the losses at all costs. He will much rather take $10 profit 10 times in a row, increasing his confidence (and often his ego) and then have 1 loss that takes all $100 away, than experience the pain from losing $10 and being wrong 5 times in a row and then making $100 on the trade that is opened with the market flow. In reality, such trader is very unlikely to last through 5 losses in a row and still continue following his system to get to that 6th trade that makes up for all his losses and more.

The risk of being wrong is rarely acknowledged, which makes it much trickier to work with. Unless a trader specifically studies trading psychology, he is rarely aware that he is actually afraid to take a trade because it might not work out.

How is it possible not to accept the risk?

In other words, how is it possible to participate in an activity (trading) that is risky by its very nature and not to accept the risk? Mark Douglas provides a very good explanation to the underlying psychology in his book:

The typical trader won’t predefine the risk of getting into a trade because he doesn’t believe it’s necessary. The only way he could believe “it isn’t necessary” is if he believes he knows what’s going to happen next. The reason he believes he knows what’s going to happen next is because he won’t get into a trade until he is convinced that he’s right. At the point where he’s convinced the trade will be a winner, it’s no longer necessary to define the risk (because if he’s right, there is no risk). Typical traders go through the exercise of convincing themselves that they’re right before they get into a trade, because the alternative (being wrong) is simply unacceptable.

Such thinking is leading to many problems in our trading. Instead of looking at the market as the source of trading opportunities he can act on, the trader thinks of it as the enemy he needs to fight. He is trying to learn everything he can about the market so that he can build such a trading system that will not lose any trades. The only way such trader can be psychologically comfortable with his trading is if he can win all his trades, since any single loss causes a lot of psychological pain that makes him start questioning his trading system.

You can imagine how difficult and frustrating such trading will be.

On the other hand, it is simply a matter of adjusting one’s beliefs and expectations about the market in order to solve this problem once and for all. A good trader does not simply say that it is possible to lose money on the market, he expects to lose money on any single trade he makes. He never knows what trades are going to be winners and which ones will pay the market for the opportunity to trade. A good trader sees such loses as the cost of doing business, similar to a restaurant owner who has to buy food before he can serve it to his customers for profit.