What is Loss Aversion?
Quite simply, Loss Aversion is where a trader is unwilling to take a loss in a current trade they have on. Rather than take the pre-agreed loss they set at the start of the trade, the trader decides to move, or even remove, their stop loss, hoping and praying that the market will return in their favour. The trader essentially is trying to ‘avoid’ taking the loss.
There could be many different reasons behind this, but the two most common reasons that are given to me by traders is a) Fear of taking a loss and b) Fear of being wrong. By hoping that the market turns and moves in their favour, the trader is essentially hoping that the pain of losing/being wrong will be alleviated.
Loss aversion is not something that is synonymous to trading, and can be experienced in many different areas of a persons life. However, when it comes to trading, if you cannot learn to overcome Loss Aversion, even if you may get lucky once or twice, it is only a matter of time before this phenomenon leads to a trader decimating his or her trading capital.
Why does this happen?
Daniel Kahneman is perhaps most recognised in discussing this topic. Essentially the way he explains it, if you were to toss a coin, (50-50 probability of winning/losing), and if you lost, then you would have to pay £1,000. The question he asked, is if you got paid ‘x’ when you won, what would ‘x’ have to be for you to be attracted to the gamble?
In most cases, ‘x’ would have to be at least £2,000, if not more. Another way to put it is, that most people would lose ‘more’ satisfaction by losing £1,000 than they would by gaining £1,000. Thus a £1,000 win would not equally compensate for a £1,000 loss.
What this means is generally speaking, humans tend to prefer ‘avoiding losses’ rather than acquiring the equivalent amount in gains.
Why is it important to cut losses?
Well, for most traders this is obvious and self explanatory. But let me give you a visual example.
|Loss on Portfolio||Gain to return to B/E|
The table here shows you everything you need to know. If you control your risk at say, 1/2/3% per trade, the gain needed to get back to parity is fairly manageable.
But let’s say you start with £20,000 in your account, and you lose 50%. Now, if this happens, you need to make a 100% gain on you remaining equity just to get back where you started. Thus, its quite obvious what needs to be done – CUT YOUR LOSSES EARLY!
If it’s so simple, why do traders struggle?
Well this is the key question. One contributory factor is how our brains process certain information under unwanted/stressful situations. If we specifically look at trading where there is the risk of losing money, most traders are affected by the loss aversion phenomenon as described earlier.
What this means in the context of trading is that traders are more likely to let their losing trades run, thus avoiding having to register a loss, and are more prone to cut winning trades early, thus in doing so avoiding a potential loss of the small profit they have made.
This is quite literally the exact opposite of what needs to be done in order to be successful in the markets.
How can a Trader manage Loss Aversion?
- Have a clear trading plan/strategy – If you have a clear trading plan and strategy, you are left in no doubts about what actions you should be taking. There is never any doubt, as you have clear written rules which can’t be ‘bent’. Thus you either follow the rules, or you break them.
- Confirm your Stop and Take Profit targets before you enter a trade – simply ask yourself the following question: “If I take this trade, where am I proven wrong? Where will I know for certain that my trade idea on this occasion has not worked out?” If you know this from the outset, then again you will much more comfortable taking a loss because you have acknowledged that if price reaches a certain level, then you are wrong, thus you exit the trade.
- Keep a statistical journal of your trading – This element is crucial and influenced my trading positively in a variety of ways. With regards to loss aversion, if you keep stats and know that your strategy definitely works and is profitable over time, tracking you winning ratio, expectancy etc, then you will be much more comfortable taking a loss because you know that over time your strategy definitely works and you have the evidence to back it up – as such, you have much more conviction in adhering to you trading plan.
- Set a Stop and Take Profit target, then simply walk away – If you find that more often that not whenever you manage a trade it is to your detriment, then quite simply walk away from your desk. Focus on something else, go for a walk, read a book. Whatever it may be, if you area way from the desk, then you can’t refuse to take a loss, and you cannot snatch your profits.
- If you have to stay in front of your screens, avoid looking at your P&L – Money is an extremely emotive subject for virtually every human. When there is money on the line, it can hugely influence our behaviour. So if you have to monitor your trades, try to avoid looking at your P&L on the trade, how much you made/lost in the session, the day etc. Instead just place your focus on the charts, and trade what the market is telling you.
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