I've asked Bob Iaccino from TraderOutlook.com to come back and give us a short article on "The Psychology of Loss" as a LOT of people have recently dealt with it. Bob's written two previous articles which you can find through this link. Please enjoy the article and visit Bob's site TraderOutlook.com for more great info.
At TraderOutlook.com we spend most of our time educating our clients in our technical trading models. We give specific levels for entry, profit and stop loss and spend a much smaller amount of our time on trading psychology. Trading psychology may, however, be the most important part of the equation and the most important part of trading psychology is the psychology of loss.
You cannot enter into a career as a trader and expect to avoid losses anymore than you can enter into a boxing ring and expect not to get hit. The hits that you remember most are the ones that you don’t get up from as they are the ones that, taken cumulatively, end your career. Wait…boxing or trading? I’m speaking of both, actually. In boxing, a terrible knockout can force retirement. In trading, a terrible loss can scare you out of you next trade or worse, end your financial ability to trade.
If your trading plan is based solely upon how much you need to make per day, week or month, you have a high probability of failure. There are only 3 possible outcomes to a trade; profit, loss and breakeven and 2 of those are good. Trading can become much less stressful if you focus on defining loss and only entering into trades with an acceptable loss. When analyzing a specific trade your first input should be “what is the proper stop level” and if that level, combined with the smallest lot size you can trade exceeds you risk tolerance, then you should not analyze the trade any further. It makes no difference if the reward to risk ratio is 3 to 1 or 1000 to 1, if the risk is too high, the trade is eliminated. Having said that, if you enter into a trade where you have defined the risk and determined it to be acceptable and the result of that trade is a loss, how can this be upsetting? The answer lies within the psychology of loss.
It is human nature to have a negative emotional reaction to a loss of any sort, especially a financial loss, but when doing trade analysis, a stop loss being hit should be looked at as one of the 3 possible scenarios, not just as a protective measure. When looked at this way, you will find yourself in fewer and fewer high risk trades and the end result will be the execution of better trades. We at traderoutlook.com do high probability trades, but yet still take the potential loss as the largest input in our decision making.
Look at trading realistically, like a boxing match. Play defense as well as offense and appreciate both. Define and accept your risk and you will control the emotional damage a loss can bring. If you do this, profits will find you.