The most important lesson in trading is how to handle losses. Most traders will encounter a string of losses at some point. Those who are thrown off their game when they lose won't survive. Traders who have realistic win/loss expectations and a trading system they trust have the best chance of prevailing. Here we look at what kind of losses traders can expect and how they can focus their strategy to deal with these losses.
Losing Battles …
Every trader knows that trading against the trend is not a good idea. So it seems logical the best systems will keep it simple and trade with the trend: go long when the trend is up, short when the trend is falling. That being said, you'd think that trend-following systems would have the best win/loss ratios, right?
In A Short Course in Technical Trading, Perry Kaufman offers sobering statistics on the matter. According to this program-trading veteran, "You can expect six or seven out of 10 trend trades to be losses, some small some a little larger." Yet Kaufman notes trend-following systems are some of the best around. In other words, trend-following systems won't yield huge profits, but still do better than most systems.
It might come as a shock to those who spend countless hours searching for a winning system, but Kaufman argues that having realistic win/loss expectations means expecting losses—lots of them. "As a trend trader, you should expect mostly small losses, some small profits, and a few large profits," he writes. "In a normal distribution of 1,000 coin tosses, half of them would be single runs of heads or tails. Half of those, 25%, would be a sequence of either two heads or two tails. Half of the remaining, 12.5% would be sequences of three in a row, and so on. Therefore, in 1,000 coin tosses, you can expect only one run of 10 heads or tails in a row."
In other words, in 1,000 trading days—or about four years—a trader could expect to experience 10 wins (or losses) in a row only once. That is, if trading were as random (normally distributed) as a series of coin tosses, which it is not.
Therefore, your odds of winning with trend-following systems are better than your odds of winning a series of random coin tosses, but there are other challenges to having more winning than losing trades. Although markets are not random, you can still expect short-term random movements within a trend, major reversals at the end of each trend and the time lag most trend-following systems experience when getting into and out of the market.
As a result, thanks to lags and unexpected short-term random movements, you are still subject to the effects of randomness. Given enough time, an experienced trader can expect to suffer 10 or more losses in a row. It is not a matter of if, but when.
If you think doing either more or fewer trades will result in a more successful strategy, think again. Kaufman notes the more trades the trader performs, the lower their profit over the long haul. On average, longer-term trades generate more eventual profits. However, if you're a long-term trader, your risk of getting one or more big loss increases, since you're in the markets longer and therefore exposed to more prolonged periods of risk. No matter what your trading style or preferred time in a trade, you will lose and lose big on more than one occasion.
Kaufman has the data to support his claims. He has performed thousands of tests on various systems. In one example, he tested Microsoft for 10 years ending January 2001 and covering a period when the stock moved from a pre-split price of $1.04 to a high of $60 in December 1999. It should be pretty easy to beat the odds following that kind of trend, right?
Using an 80-day moving average during the period to generate buys and sells, the system generated 88 trades, trading both long and short positions. Of these, only 36 trades—or 41%—were profitable. Kaufman writes, that's "actually good for a trend system, which often has closer to 35% good trades."
These depressing stats are echoed by John Murphy in, Technical Analysis of the Financial Markets. Murphy says professional traders, on average, lose 60% of their trades and only win 40% of the time. Given the grim facts, rookie traders may wonder how it's possible to make money. All of this begs the question: how can a system that has more losing trades than winning trades be profitable?
... While Winning the War
Let's look at an example of a system that does very well in a relatively short period, but falters over time. This author ran a number of tests to determine whether using commercial commodity traders' net positions—published each week by the Commodity Futures Trading Commission in the Commitment of Traders reports— was useful in trading an index. Tests were performed for the period of 1999 through 2003 using S&P 500 Index futures.
Using a five- and 22-week simple moving average of commercial traders' positions, buying each time the five-period SMA crossed above the 22-period SMA and selling when it crossed below, the strategy earned 804 points. Contrast this to a loss of 245 points for a buy-and-hold strategy during the four-and-a-half-year period between Feb. 12, 1999, and Oct. 3, 2003. If we assume the trader traded one S&P 500 e-mini contract with a margin (risk) of $1,800, the profit would have been more than $40,000 after commissions. Out of 12 trades, seven were profitable—that's a win/loss ratio of 58%.
The same tests were performed for the 13-year period from Feb. 16, 1990, through Oct. 31, 2003. Results were far less impressive. The system returned a total of 555 points, whereas a buy-and-hold strategy over the same period returned 696 points. The win/loss ratio also dropped: only 26 out of 55 trades were profitable, for a 47% ratio. Not only was the system not nearly as impressive over the longer period, it was also significantly outperformed by a simple buy-and-hold strategy.
The Take-Away Value
The moral of the story? Whenever you see claims of systems generating outstanding returns over short periods, remember that such statistics are worthless without looking at the bigger picture. Even worse, these claims often create unrealistic expectations in the mind of the new trader who takes them at face value.
When you approach trading with the assumption that there will be more losing than winning trades, your primary focus shifts dramatically. Instead of spending inordinate amounts of time buying, testing and discarding systems that fail to meet your unrealistic expectations of 70 to 80% (or more) wins to losses, you can concentrate your efforts in the more important area of money management.
Traders tend to spend far more effort on seeking the magic formula for trading than on learning to manage the trade. This is obvious if you compare the number of trading signal systems available to the number of money management systems available. The same is true for best-selling trading books. When was the last time you saw a best-seller that concentrated on money management? This may explain why so few traders graduate to the point of being consistent in the trading game.
The Bottom Line
Because professional traders typically experience more losing than winning trades, learning how to lose is essential to making it as a trader. Furthermore, an effective money management program is absolutely necessary to a trader's survival and long-term profitability. A key part of any money management program is building an effecting trading plan and sticking to it.
Consider what veteran trader Larry Williams said in a 2004 e-mail: "Since losses are an integral part of this game, a strategy is as essential as the proper attitude. All jobs have good days and bad days so deal with it. There are no 100% certain trades."
Looking for a system that will win 80% of the time or more is a fool's game. Those who adopt a hope-for-the-best-but-plan-for-the-worst mentality and concentrate their efforts on far more important issues will set themselves up for long-term success. It is the difference between taking a short-term view to win a few battles at any cost and marshaling resources in the battles you lose to ultimately win the war.
If you're serious about getting a handle on this topic, check out the book by Kaufman discussed in this article. You will also find Thomas Stridsman's book, "Trading Systems and Money Management," a worthwhile read for its detailed discussion of win/loss ratios, realistic expectations for various trading systems, and money management strategies. Consider it a reading assignment with potentially big dividends.