The 3 Hardest Things In Trading
Part 1 - Trade Management OR The Art of Sitting on Your Hands
Traders, in particular new traders, spend most of their time focused on finding a strategy for picking winning entries into trades. But, for me at least, that is not one of the hardest things in trading. This series will highlight the 3 things that I think are the hardest skills or techniques to master in trading. Having conducted 60 trader interviews over the last 13 months or so, I am also going to distill some of their wisdom for you. First up: Trade Management. Or, The Art of Sitting on Your Hands.
Regular listeners of the podcast will know that Tom has spent much of the past 13 months berating me for my flapping and indecision when it comes to my trade management. Though, when we first started I didn’t call it ‘Trade Management’ as I’d probably never heard the term. But rather I just thought of it as ‘what do I do once I’m in a trade?’
Once You Are In, You are In, Until You’re Not In, Or Are You?
My original flap came with what to do with weekends. When Friday’s closing bell rings (more of a collective sigh, I suppose, in the Forex markets) what do you do with your open trades? Do you close them and destroy your planned Reward:Risk ratio? Or do you hold them over the weekend and risk your reason for entry being obliterated by some mega-news while the markets are shut? Nobody likes knowing for a full two days that they are inevitably going to get kicked in the balls by a gapped market on Monday morning.
For a long time I was deciding on definite rules like “I will always hold my trade over the weekend” and then I’d be 5 pips off my target with 3 mins to close and be like ‘bollocks to it, I’m taking my profit”. And then, of course, get utterly destroyed by Tom on Monday’s podcast.
This, naturally, opened the floodgates and soon I was closing trades on Friday afternoons that were only 10 pips into profit for fear of losing my (tiny) gains on Monday morning!
This Friday Fear became a real problem, particularly as my trades often ran for 2 or 3 days. So, I thought, does that mean I can’t trade on a Friday, or Thursday or even Wednesday??
Sometimes that problem manifested itself at normal end-of-day closes, or even trades that were running before some big data. As a day trader I tied myself in knots about this stuff. I don’t how many times I committed (even on the podcast!) to having a ‘hold my trades until completion’ rule which I then binned-off as soon as the NFPs were due. Or even just some French inflation data if I was feeling particularly twitchy that day.
I am pleased to say that I did overcome this, and these were largely just newbie trader problems for me. But I do still feel a twinge when holding over the weekend. Now that I am Swing Trading, I don’t really have much choice of course!
Discretion is a Pain
The idea of sticking to hard and fast trade management rules became more difficult for me the more discretion I was using in my entries. So, when day trading I never really used a fixed Reward:Risk ratio - no strict 1:1 or 2:1. My entries and exits were, initially, based on signals from the indicators I was using; Bollinger Band crossovers, Fibonaccis and ‘fair value’ hits etc.
This made ‘sitting on my hands’ a bit more tricky as there was often subjectivity involved. But what really ramped up my exit-anxiety was my move to Fundamentals and Sentiment based Forex trading. That entire thing is subjective! So the idea that I would patiently wait until my original target was hit when I was sat with my Ransquawk feed on all day, hearing news and seeing reasons to exit time after time....well, that was never going to happen!
As I said, I overcame all of this nonsense eventually.
Part of the reason I managed to get past this constant desire to fiddle with my trades was the simple accumulation of experience. Or, rather, maturity.
When you are a kid everything is either scary or exciting. The same goes for new traders. Once you’ve been around the block a bit and seen a few trades, it is just natural to be more able to chill and let things play themselves out.
I don’t know if there is any substitute for experience with this particular foible, or if it is inevitable that all new traders will go through a period of cutting their winners short, messing around with stop losses etc. But, becoming aware that you are trading sub-optimally is the first step!
There is a place for Trade Management, a Big Place!
All of this is not to say that there is a never a place for trade management! I am not advocating ‘fire and forget’ as the only form of acceptable trade management.
We have spoken to many profitable traders on the Two Blokes Trading podcast and while plenty never look at a trade once they’ve placed it, many of these traders do have an active trade management approach.
Some traders swear by a discretionary approach to stop-loss management. Many like to take half their profit at an easy target and then run the other half for as long as possible. Some traders will get out ahead of big news events regardless of the trade’s status, others only if they are currently in profit. There is certainly a place for considered, rules based trade management.
3 Ways to Improve Your Trade Management
Not being a fan of the 21st century victim mentality, I didn’t want to finish this piece on a whinge. Trade management is difficult, but entirely possible to do well. I am in the privileged position of having a podcast that allows me to interview a different profitable trader every week. One of topics we often cover is trade management.
So here is some of their advice:
- Rules Based on Empirical Evidence
Our avid reader(s) will know that I have discovered a love for rules, possibly for the first time in my life.
Tom and I are currently in the middle of honing our trading craft with the programme laid out by Traders Support Club. Ali Crooks, Founder and Head Trainer, has hammered home the need for all aspects of your trading to be based on rules. Those rules themselves must based on empirical evidence.
The trade entry strategies they have given us to trade have been proven by Ali, through backtesting, to be profitable. His trade management techniques are no different.
His clear leap of logic is that if you want to know whether you should close your trades on a Friday, or move your stop to breakeven, or take half your profit at T1, you have to do one simple thing: backtest it.
If you can prove that you make more money when you move your stop to breakeven when you are 50 pips in profit on your particular strategy, then are a fool if you don’t move it! You are also a fool if you move it after 45 pips if you know that generates less profit over the long term than if you wait till 50 pips. It will also be far, far, easier to actually follow this rule if you know through testing that it will, on average, make you more money.
Ali Wan Kenobi
My mother would be surprised to discover that the first person to get me to listen to the rules was a bloke called Ali from Northampton. Although possibly she would be less surprised if she realised that he convinced me to follow rules because it would make me cash.
That’s the key here. If you are going to stick to something it is because you have to know it is going to make you more money in the long run. I’m not doing what Ali says because he has Jedi mind control powers (I hope), but because he laid it out in black and white - one path leads to more money, the other path to less money.
2) Man, Know Thyself
A favourite phrase here at Two Blokes Trading is ‘know thyself’. When I put it to Ali that you should build your trade management system around your personality as much as proven rules he wholeheartedly agreed. As long as you still used proven rules, of course!
When Moritz Czubatinski (creator of Edgewonk) was on Episode 16 he told us that he regularly moves his stop to breakeven as quickly as possible. This is because, for him, the hardest thing psychologically is taking a loss after being in a winning position.
I feel his pain. For me, giving profit back as a loss has always been the thing that gets me on tilt the most. It is also the thing that I fear above all; explaining my reluctance to hold trades over the weekend when they are in profit!
Moritz and I know this about ourselves. This is the first step. Second, he decided that he would build a trade management system that acknowledged this about himself and turned it into a strength. For me, having recently switched from day trading to swing trading, I will have to decide to what extent my trade management strategy will take this personality quirk into account.
Everyone Has Their Own Issue
For you, maybe the issue is something else, maybe it is wanting to never take a loss at all. Or hating it when a trade goes instantly against you. I have no issue with trades that go against me and hit the stop, even if it is virtually straight away. I know other traders who loathe it when this happens. These traders, particularly when new to the game, are more likely to fall into the trap of widening their stop loss to prevent it from getting hit!
I don’t know of many profitable traders who routinely do this...but if you have taken the time to know thyself and you have this issue, then you can begin to work on a solution. Perhaps creating a set of definable rules that allow you to move your stop away from the price under certain circumstance only.
3) Do The Maths
This is related to point one - you need empirical proof that a certain strategy will make you money. But it is important that you take the time to understand how certain trade management techniques affect the maths of your trading, in particular Reward:Risk ratios.
In Episode 57 Akil Stokes came on the show and talked a little bit about a problem he once had with running two separate profit targets. He would take half his profit at target one (T1) and half at target two (T2). He would bring his stop loss to breakeven when he hit T1. This is an extremely common strategy, that many, many traders use.
Akil had done some testing and his results suggested that T2 would be hit regularly and so he decided to gun for it with half his stake. But over time he found that he was actually making less money. So he sat down and did the maths. He realised that only closing half his position at T1 totally undermined his intended Reward:Risk ratio.
Reward:Risk Ratios are Easily Ruined
If you have a Reward:Risk ratio of 1:1 between your stop loss (SL) and your first target (T1) then you need to have over 50% of your trades to be winners in order to be profitable, depending on trade costs etc. Ok, so far, so obvious.
But, if you start with an R:R of 1:1 and you only take half your profit at T1 and you run the other half to T2 then you have completely destroyed the maths. You are then in effect risking a whole stake and only taking back half your stake profit at T1. You have actually created a Reward:Risk ratio of 0.5:1.
The fact that you may then may make more profit with the final half stake is an irrelevance in my mind, as once you have brought the stop to breakeven you are, in effect, entering into an entirely new trade with a new SL and new target at T2.
Even if you don’t bring your stop loss to breakeven, and you just run the second half of your trade to 1.5:1 or 2:1 or whatever, do you truly understand the impact that has on your Reward:Risk ratio?
Crap at Maffs
I tried to do the maths, but I never got past GCSE maths and I’ll admit that I got a bit lost. (Can you take the 1.5 second half of your trade, times it by 0.5 to get 0.75:1 on that half, add this to the 0.5:1 and get 1.25:1? Or is that total bullshit maths? Can you actually look at ratios like that? I suspect not. Answers on a postcard please. Or a tweet...)
If you can answer this question with a definite answer, if you know the true Reward:Risk ratio of your trade at entry, and you know that running multiple targets is better mathematically for your P&L, then great, crack on. But if you don’t, and you are no more able to answer the question above than me, then maybe you need to think twice!
Does it matter?
The counterargument to this is: if you backtest your strategy over 1000 trades or 10 years etc. and it is more profitable to have multiple targets than one target, then what does it matter what the mathematical probabilities are? And I agree, to some extent. Given that hitting T2 or T3 is less likely than T1 as they are further away, that screws with the probabilities anyway, so maybe just go with it.
But I am interested in Reward:Risk ratios because the best data out there shows that having a positive R:R is the stat that is most likely to predict winning traders. So, if you can’t even tell me what your actual R:R is when you enter a trade, I’d say you are at a disadvantage and your trade management is likely to be sub optimal.
I daresay this is where Tom accuses me of over-analysing things, but I can’t help who I am! And I simply can’t trade a system or use a trade management technique that I am not sure I fully understand.
No Shortcut to Success
There is no shortcut for this and the markets will show no mercy to those with lazy thinking and a corner cutting mentality. If you trade a system like above and you have failed to take into account these realities, then you are in danger of trading a broken system. It could be vastly less profitable than it should be, or perhaps even unprofitable, because your faulty trade management system undermines your backtested and proven ‘Edge’ for entering trades!
From a psychological perspective I find trade management the hardest part of trading. From a logic/maths and backtesting perspective it is also comfortably the most complex part of trading. But, it is so, so important.
You can add a tremendous amount to your profit by having a good system of multiple profit targets or active stop loss management.
But if you arse it up by being sloppy or mentally weak then you are far more likely to end up destroying those profits than enhancing them!
Tom and Owen trade with XTB due to their fast trade execution and award winning trading platform. To find out more and benefit from a 15% spread rebate when trading visit www.twoblokestrading.com/xtb