Trading 101: The Key Ingredient to Sustained Success is Failure

My trading style uses fairly tight stop loss settings, which demands that my entries be pretty accurate with a small margin of error. In some trading circles, this would be seen as being “amateurish” for not allowing your trade to have breathing room to deal with the range of market volatility. Of course, most of those same trading circles view the market as mostly random in the short term that must be met with a ball park entry with a wide stop loss.

I used to trade with wide stop loss settings, or threw caution to the wind with “mental stops” rather than actual programmed stops. The market can gyrate so much that it’s an easy habit to get into. The market rarely moves in a straight line and can drift back and forth before making a definitive move in a particular direction. When stops are tight, it’s easy for price to move just enough against you to trip the stop loss before moving in the anticipated direction. This often happens enough to be a common frustrating experience among traders.

Using wide stops gives you more leeway when in a trade, but that also means your losses will be greater when they are tripped. Of course some traders don’t use stops at all- as that guarantees you will never be whipsawed out of a trade, but that also leaves you without protection if the market makes a big move against your position.

Not using stops is high risk, yet most traders including myself have engaged in such behavior due to the frustrations of getting whipsawed out of trades that would have eventually worked. But eventually the Grim “Stopless” Reaper cometh and will make you pay for not using stops. Eventually one learns to incorporate hard exits via stops, or the market will do it for you with severe losses that can blow out your account.

Over time I’ve learned that while using stops can be frustrating, and using tight stops VERY frustrating, it forces you to really focus on your trading system to find ways of improvement. Typically when a trade is entered that doesn’t work out, it’s one of three things:

  1. System is correct, but market had a random spike/dip due to some late breaking news.
  2. System is correct but the application of system was wrong.
  3. System has flaws that need to be worked out.

Out of most events encountered, #1, is VERY rare, while #2 is more common and #3 is typically the most common. One could say that #2 is a subset of #3 since proper execution is also part of the system.

I’ve been working on precision trading, where one can trade the daily battle between resistance and support with a fair amount of accuracy so as to not need to use wide area stops. Using tight stops and the ensuing failed trades and frustrations that resulted were actually great motivation in improving my trading system.

I find that my post trade analysis of failed trades have been responsible for the bulk of my trading system evolution. Preparation and planning can only go so far but I seem to be able to pick up so many more fine details of what went right and wrong when the analysis is done right after the trade is finished- likely because my plan is fresh in memory so it’s easier to pinpoint the aberrations. It’s a great feeling to spot a problem that was previous missed that when fixed, improves the accuracy of my system.

It’s a lesson I like to forget – that failure is a part of progress, since it opens the window for improvement. To get the best out of failing, it helps tremendously to have a clear and concise system trading plan that you can back track step by step to see what went wrong as well as what went right. A big mistake I’ve seen other traders make is “winging” trade entries in real time without a clear plan of specific entry and exit strategy. The point of system trading is the eliminating of seat of your pants “ad lib” style trading.




Trading Update: Hidden Bonus of Stop Loss Orders

Another good week for improving my system during live trading. Of the seven trades made this week:

Trade 1: Stopped out – loss.

Reason: On wrong side of trade – went long when I should have been looking to short.

Trade 2: Stopped out – gain.

Reason: On right side of trade, but market backtracked enough to stop out my position before continuing move.

Trade 3: Stopped out – loss.

Reason:  Entered trade too early- got whipsawed out.

Trade 4: Profit target hit – gain

Trade 5: Early exit – gain

Reason: Market making unanticipated movement – prompting trade close out to cut risk.

Trade 6: Stopped out – loss

Reason: Failure to manage trade properly, resulting in gain turning into loss.

Trade 7: Manual exit – gain

Reason: Incorrect profit target put in- as a result trade never reached target point and had to manually exit with a smaller gain.

Each trade enabled me to increase the accuracy of the following trades, but this was an interesting week with stop loss orders. On almost every trade that I got stopped out on – trades # 2,3 and 6, I got stopped on the “exact tic” – meaning that the market price moved to my exact stop loss value before reversing and going the other way. In other words, the market in those cases moved against my position just enough to trigger the automatic close out of my trade before moving in the direction I anticipated in the first place. It’s what’s known as being “whipsawed” out of your position, and when it happens on the exact stop loss value you entered, it’s hard not to take it personally- as if the market is personally “trying” to stop you out of your position. Of course this can’t be true with the multitude of other traders orders out there but it still feels that way. =)

When close stop outs/whipsaws like this happen – the temptation is to not use stop loss orders- since if none were in place, those trades would have all been winners. It’s a bad temptation though, since stop losses protect your account from taking heavy losses.  Trade #1 is a perfect example of that. I was on the wrong side of a trade and not having a stop loss would have cost me plenty.

While I did feel very annoyed how I was getting stopped out, my annoyances went away and I was forced to consider the true problems at hand. The problem wasn’t the market being against me, but either my trade entry wasn’t timed well enough or my measured stop-loss risk needed to be larger.Once I took ownership of the problem, I was able to find solutions in increasing my market entry accuracy.

The stop-loss being triggered revealed a trading problem that needed solving rather than the need to reject stop loss orders. Why it took me this long to come to this realization I’ll never know. =)  As a result of my improvements, trade #7 would have been the best trade of the week in terms of profit IF I had determined the right exit target. I was close, but missed it and the market reversed and took back much of the gains.

Overall this week was another good one with 6 of 7 trades being in the right direction and my ability to determine the best entry price improves with every trade.