Trying to Avoid Losing Trades Is Actually a Huge Trading Mistake

Avoiding losing trades actually depletes profit potential, here's why...

trading mistake of avoiding losses
Take your trading losses; it will make you more profitable. moodboard, Getty Images

It's counter intuitive. How can avoiding losses be a trading mistake? Losses take money away from us, so humans have a natural tendency to try to avoid losing. Trading is a counter intuitive endeavor in many ways though. This natural tendency hurts you as a trader. Here's why, and how to overcome it, so you can become more profitable by accepting--even embracing--your losing trades.

Trading Statistics and the Trading Mistake of Avoid Losses

Trading statistics are simple figures, such as your win rate (how many of your trades are winners) and reward-to-risk ratio (how much you typically win on a trade compared to how much you typically lose). Day Trading Statistics for Tracking Performance goes into these measures, and others, in more detail.

Suppose I offer you a game where you can win 55% of the time, and a win is worth 1.5 times as much as a loss. How would you approach such a game? You know that the longer you play your odds are very good that your capital will grow.

You bet $10, and lose. Do you keep playing? You bet another $10, and lose. What about now? Another $10, and you lose again. Most people start to question the legitimacy of the game at this point. They are down money, feel a little taken and decide to try to make money at something else. The losses have discouraged them, and they have made a fatal error (assuming I wasn't actually trying to scam you...and I wasn't).

The fatal error is to stop, or switch games (switching strategies in the case of trading). If you keep playing, over many bets--or over many trades using a strategy with these performance statistics--the odds are heavily in your favor. 

A 55% win rate means you win 55 out of 100 times, and lose 45 times.

Those wins and losses can be distributed in a vast number of ways. It's theoretically possible to have 55 wins in a row, followed by 45 losses, or vice versa--still a 55% win rate! While you lost three in a row, someone else would have won three in a row. While you know the odds, wins and losses are still randomly distributed within those odds. A single trade is a basically a coin flip...but over many trades we see the statistical edge.

People trust statistics when they aren't playing, but when they actually have money on the line, all of a sudden they assume the statistics must be flawed, someone is scamming them or they simply don't want to risk losing any more (mentally, a loss is assigned greater weight than an equivalent gain).

Losing is a Requirement of Profitability

At the outset our game we defined our win rate and reward-to-risk ratio. Both were favorable. This is like a trader who has practiced for multiple months developing consistency, taking trades each day and recording the results. After six months of profitably day trading the forex market she sees her win rate and reward:risk over 756 trades (a good sample size, based on 6 trades a day) is 55% and 1.5:1 (for example, she makes $15 on winner, and loses $10 a loser).

 

This trader now KNOWS that she is likely to lose 45 times out of every 100 trades (approximately). If she loses three trades in a row, should she be concerned? No. You can actually think of losses as your pathway to profitability. This trader knows that if she sticks with her trading plan (the one that made her successful for six months in the demo account), she will eventually receive the fruits of her statistical advantage.

The potential fruits of her statistical advantage are (assuming a $5000 account, 126 trades per month, and risking $50 per trade (which is 1% risk)):

126 x 0.55 = 69 winners x $75 = $5175*

126 x 0.45 = 56 losers x -$50 = -$2800

Net profit = $5175 - $2800 = $2375

*Winning trades are $75 because she is risking $50, and wins, on average, are 1.5 times greater than losses.

$2375 is the reward on her $5000 account, each month, for sticking to her plan.

Account for commissions if using a non-commission-free forex account, or if trading another market.

We Don't Know in Advance Which Trades Are Winners

Our trader only gets her reward if she sticks to her plan. That means she likely has to lose about 56 trades per month (based on her stats, which will vary by trader), in order to win 69, producing the $2375.

We don't know in advance which trades will be profitable and which ones won't. If she did know, her win rate would be higher. The fact it isn't tells her she DOESN'T KNOW...she is only right about 55% of the time. 

It's a trading mistake for our trader to assume she can avoid some of these losing trades (which her strategy tells her to take). In an attempt to avoid losers, she is also likely to avoid winners, inadvertently, which are worth 1.5 times more than losers. 

Missing a winner hurts more than avoiding a loser. If she avoids a loss she saves $50, but missing a winner actually costs her $75 out of her $2375 profit potential. For each missed profitable trade she depletes the pile of cash waiting for her at the end of the month. Any trade skipped has a 55% chance of being profitable; there is a greater chance of avoiding a profitable trade than avoiding a losing one! Our trader has abandoned her plan, and will be much less successful than she could be. 

It is actually quite possible she could become a losing trader: by trying to avoid losers she is no longer trading the same profitable strategy, in the same way, she was in the demo account. Variables have been changed, which will completely change results.

Final Word - The Trading Mistake of Avoiding Losses

Using various analogies and ways of thinking, hopefully you no longer consider losses a bad thing. Losses are an integral part of your strategy, the results of which produce the cash waiting for you at the end of the month...but only if you take all the trades you are supposed to (and your strategy has proven profitable). You don't know in advance which trades will be winners/losers.

Market conditions change over time, so trading statistics will fluctuate. For example, in some month 126 trades will be very high for our trader, in other months low, based on the opportunities presented. In any given month our trader's real profit potential may be higher or lower than $2375, but over many months, that should be the average. We have also assumed the 756 trade sample size truly reflects this traders strategy and profit potential. It is possible it doesn't. This six month period may actually be low or high, when compared to a 24-month average of her profitability. Trade in a demo account, get to know your statistics by trading for at least several months, and then trust those statistics when you switch from demo to live trading.

Sign up for Cory's weekend newsletter, which includes stocks, futures and forex pairs to watch, as well trading tutorials.