This article, which examined 70M+ trades, emphasizes the importance of keeping your losers small and your winners big. The concept is simple enough, yet the vast majority of traders fail at trading because they struggle to do this effectively over time. As the article explains, most traders do the opposite: They cut their winners quickly and let their losers run, which results in a positive win rate but a negative expectancy (the negative expectancy matters a lot more – unless you like losing money with a high win rate). Note: I refer to R-Multiples a number of times in this post – if you’re not familiar with them, then read Van Tharp’s informative explanation of R-Multiples.
Possessing the ability to both 1) respect (and accept) your initial stop loss (risk) and 2) let your trades run to their targets, amidst a sea of volatility, rotations against your position, and uncertainty, requires four skills (trading virtues, really) which many traders never develop: Patience, Discipline, Confidence, and the ability to read a market Contextually.
In trading, Patience, Discipline, Confidence, and the ability to read a market Contextually come through experience, repetition, homework, your developed intuitive connection with a market, your ability to trust in your edge, and your ability to trust in your placement of objectively relevant invalidation points (stops) and price targets – all of which are acquired by truly experiencing a market. You truly experience a market via focused observation.
With focused observation:
- You closely and intentionally observe a market’s price movement, paying close attention to how it moves under different conditions, how it moves at different times of the day and days of the week, how it moves in relation to other markets, how it moves with different levels of volume, how it reacts at particular support and resistance levels (on different timeframes), how it reacts to news or economic reports, etc.
- You do not see a market for its lines, candles, indicators, and shapes, but instead, you see it as a living, breathing, collective set of emotions and behaviors by human beings (and machines, which are programmed by human beings) from around the world.
You must immerse yourself in a market via focused observation if you truly want to master it. When I began my trading career, one exercise that I followed which made the biggest difference in my trading is the following:
Focused Observation Skill Building Exercise
Step 1: Focused Observation
First, get rid of everything on your chart except price and volume (indicators are primarily just derivatives of price and volume, anyways). It is essential that you get rid of the noise and just focus on price action. Focus is the key word here, son.
Next, don’t place – or think about placing – any trades. Instead, watch your market of choice (if possible, try to only watch one market so that you can work to develop a connection with it; the more markets that you try to watch, the less connected you are going to be to a particular market). Record your observations of the market each day that you’re actively observing it. Pay close attention to price movement, how price reacts at specific levels, how price moves after news or economic reports, how price moves with different levels of volume, how price reacts to objective invalidation points, how price moves at different times of the day and days of the week, how price moves in relation to other related markets or trading vehicles, etc. The key is to stay focused (you must stay focused, so get rid of any distractions that are present). It is through focused observation that you will be able to develop the ability to detect subtle nuances in your market which will give you a competitive edge.
Understanding and developing your ability to read the market contextually is an important part of trading and it is a skill that you can build through focused observation. Make sure that you are watching your market on multiple timeframes – this is how you will improve your ability to read the market contextually. Context is an extremely important part of being a successful trader. You must be aware of where price is and how it has moved on the smaller timeframe (a 5 minute chart, for example) in the context of the larger timeframe (30 minutes to an hour, for example). Timeframes will vary based on your trading system, but it’s important that you always keep in mind the bigger picture and how price contextually fits into that on the smaller timeframe.
Do the aforementioned for a few weeks to a few months. Repetition is an important part of skill building, which is why engaging in this part of the exercise for a few days simply won’t cut it; the longer that you can do it, the better. Remember, you are building a connection with the market – a connection which will help you develop patience, discipline, and confidence – essential trading virtues that all profitable traders possess.
Step 2: “Marking” Your Trade Ideas
First, bring back only the indicators that are absolutely essential to your edge or methodology. If it doesn’t contribute to your edge, keep it the fuck away. Indicators are mostly just lines on a chart that inflate your sense of sophistication and knowledge when it comes to market technicals. Most of it’s bullshit, based solely on past price action and volume and not the present and future, which is what matters (unless you’re a dirty hindsight trading extraordinaire).
Next, still not placing any trades, continue observing that same market, but now, begin “Marking” the chart (in your head, out loud, in your notes, or on the actual chart itself with drawing objects from your trading software of choice). Note: The following must be done in real time – none of that hindsight trading bullshit that I see every day on Twitter from the top hindsight traders. You must be honest with yourself. Don’t worry about being right or wrong, honesty holds the key to building a strong connection with your market. “Mark” the following for each valid trade idea (which is determined based on your unique edge criteria):
- When and where you think it’s a good place to enter (i.e. your edge).
- An objectively meaningful place for an invalidation point (stop).
- An objectively meaningful place for a target. Make sure that your target is at least 2x (2R) what you’re risking on the trade – this is a key element of success for the vast majority of traders.
- Note: Your entry, invalidation point (stop), and target should all be at price levels that are objectively meaningful to the market (e.g. an area of horizontal price resistance), not at arbitrary price levels which mean absolutely nothing to the market.
With your “Marked” trade “on”, let the trade play out. Take note of rotations (moves that go against your position, assuming price initially goes in the direction of your “Marked” trade). Notice how deep or shallow the rotations tend to be. Price rotations are a normal part of trading in all markets. Some are deeper than others, and some shallower than others, but they are always present. Notice how often, after a rotation against your position occurs, that price continues to move in the direction of your trade idea and hits (or comes close to hitting) your initial target. Do this over, and over, and over again – for weeks – Observing, Marking, Note taking, Repeating. Repetition is key. Pay attention to how well you are interpreting market action. If you seem to be misinterpreting price action more than you’re interpreting it correctly, then go back to Step 1 and just observe the market. Eventually, the mental maps that are being constructed in your mind via focused observation should begin to emerge in your ability to effectively “Mark” valid trade ideas which hit their respective targets.
Note: If you find yourself getting stopped out of your “Marked” trades, then look to widen your stop loss, and see if that makes a difference. If you do need to widen your stops, then make sure that you are still setting targets that are at least 2x (2R) your risk and that the invalidation point (stop) and target are always based on objective price levels in the market. When you go back to real trading, you need to make sure that if you are widening your stop, you are also adjusting your position size accordingly to compensate for that wider stop. Download and use my Position Sizing Tool Google Sheet if you don’t already have a tool to make dynamic position sizing based on stop loss size an easy process.
Step 3: Simulated or Live Trading
Once you have completed each step of this exercise (in total, it should take, at a minimum, 1 month; I spent 3-4 months doing this before trading with real money), trade on a simulator or with real money, taking everything that you’ve learned and applying it. As you trade, you must continue to focus on observing the market. Make trading decisions that are contextually meaningful. Use the confidence that you’ve gained through focused observation to be more patient and disciplined with your trading.
Benefits of the Focused Observation Skill Building Exercise
Through the lens of focused observation and “Marking” of your trade ideas, you will begin to become more in tune with your market, growing more confident in your ability to detect subtle nuances which can provide vital market information that only the most focused and connected traders can detect. In addition, you will more confidently accept the fact that rotations against your position will almost always happen, and that many times had you micromanaged the trade (i.e. moved your stop loss to breakeven in an area that was absolutely meaningless to the market in order to give yourself a “risk-free” trade), you would have been stopped out during a normal rotation against your position prior to the market proceeding in the direction of your trade idea. You must learn to resist micromanagement and, assuming you have a meaningful edge, you must learn to and grow comfortable with letting your trades play out to either their invalidation point (stop) or target.
By partaking in this exercise for a few months, you will undoubtedly build:
- Patience to wait for valid trade ideas to develop at good trade location.
- Patience to let your trade ideas play out, in either direction (to stop or to target).
- Discipline to keep constant your risk on each trade (-1R).
- Discipline to define, set, and respect your objectively defined invalidation point (stop), no matter what, knowing that it represents a meaningfully objective invalidation point in the market which in turn represents your acknowledgement that you do not have control over the outcome of any trade no matter how good your edge may be (read “Trading in the Zone” to further develop this important mentality in the market – a mentality which all successful traders possess).
- Discipline to define and set your objectively defined price target(s) (at least 2R your risk).
- Confidence to act on your edges without reservation or hesitation at good trade location.
- Confidence in your ability to read your market.
- Confidence in your ability to hold a trade from entry to exit, regardless of price action, knowing that rotations are an absolutely normal part of trading, and that you must accept and embrace rotations against your position in order to hit your 2R+ targets.
- There will be times when a trade is up 2R+ and price reverses and takes you out of the trade for a -1R “loss”. Similar to when a stop loss is taken out, you must look at these trades as “cost of doing business” trades. Each time a stop is hit, you are one trade closer to capturing a more meaningful 2R+ trade idea – the stop execution was simply a cost of doing business to get to that bigger winning trade. If you get into the habit of cutting your winning trades before they reach your target, then you will essentially be doing what the majority of losing traders do – cutting your winners quickly. As the article at the beginning of this post clearly states, that (along with letting losers run) is the primary reason why most traders fail. This is why it is so important to build confidence through focused observation (and “Marking” your trades) so that you can confidently resist the temptation to partake in the action of micromanagement that will significantly decrease your chances of success.
- Though it is generally best to leave a trade alone once you enter with set risk and target, there are times when an open trade’s active Risk/Reward (think of it as a mark-to-market of the trade’s current Risk/Reward) reaches a disadvantageous point. Specifically, if price action is not behaving in a manner that bodes well for your chances of actually reaching your target and you have more R to lose than you do to gain if you were to continue holding to your original target, then at that point it would make more sense to close the trade. For example: Say you are up 3R on a long trade that has a maximum of 3.5R potential at the target price that you set when you entered the trade. Price is clearly stalling and topping out just ahead of your target and you know, based on your read of the market, that if the market fails at the current price, then it will likely go all the way back down to (and potentially through) your original entry price. So, with an objective red flag in price action, you are risking your current profit of 3R (if price fails and pulls back to your entry price (where you moved your stop loss after a higher low formed, acting as a new objective invalidation point)) to make .5R (your original target, which is .5R away from the current price). In this situation, it makes more sense to cut the trade than it does to hold it since you’re risking 3R to make .5R. However, it’s important to spend a considerable amount of time not interfering with your trades once they are opened. More harm than good will come from this. As you get more experienced, then it makes sense to be a little more fluid when it comes to these types of scenarios.
- An ability to read a market Contextually
- Understanding where price is, how it got there, what it means, and what market participants are likely thinking on the smaller timeframe in addition to how that relates contextually to the larger timeframe (price and participants) will give you the ability to make more informed trading decisions – a skill which will set you apart from the average losing trader who executes trade ideas without any regard for the ever changing variables that make a market, a market.
As I said earlier, engaging in this exercise made a huge difference in my trading. Why do 90-95% of traders fail? Because they don’t have Patience, Discipline, Confidence, and the ability to read markets Contextually. If you put in the time, energy, and focus, this exercise will help you build each of these skills, which will in turn, help you to become a better trader.