7 Reasons You Can't Cut Your Losses | Trading Psychology

Hello and welcome to lesson five of the advanced Psychology course for High performance trading. This video is addressing the issue traders face with cutting losses or not being able to, and therefore taking much bigger losses than they should. If you've ever felt the urge to move your stop loss, not use a stop loss at all, or you've been tempted to use Martingale or Grid trading strategies in an attempt to avoid taking losses, then you've made this universal mistake. It's a simple piece of trading advice to cut your losses, and yet few beginner traders are able to follow it. And you'll understand why once we look at the System one pushes and decide for the causes that are working behind the scenes. There are seven main causes for this. You'll be familiar with the first four from the previous videos, but in this video we're looking at them specifically in context of leaving losing trades open. And there are an additional two completely new concepts for this video that we haven't explored previously. So let's start with winning. We already know it's easy to see individual trades as a battle that you win or lose. In a winning trade, you're already winning. So it's fairly simple to just take profit early to secure the win. And you're not going to do yourself much harm. In a losing position, the effects can be catastrophic and the harm you do to yourself enormous. To start, there's much more pain associated with losing and immediately cortisol and other stress hormones are released into your body. If you remember the S shaped curved I showed you in prospect Theory in lesson three, the pain of losing is exaggerated, proportional to the satisfaction of winning for your ancestors. Losing a battle often, perhaps usually, meant death. System one is wired to avoid losses at all costs. So every survival instinct you feel is massively exaggerated. In a losing position compared to a win position. System one is going to be in full control if you're not careful with System 2 completely offline, leaving you no ability to logically follow your system rules. To avoid this, you need to spot the early signs and the physical symptoms that indicate that you are seeing your trade as a battle to be won. It's about self awareness as always. Look for things like an elevated heart rate, rapid or shallow breathing, a knot in your stomach, sweating, restlessness, agitation, perhaps even having a short temper with family members who are nearby. Remember that system one out of the box. It doesn't understand that the risk you face in trading is not a risk to your life. It assumes you are in physical danger, so it is preparing your body for a Physical response. And of course the obvious sign to look for is the fact that you are delaying taking the loss. And that may sound silly, but if you're paying attention, as soon as you feel like moving your stop loss, you're getting a signal clear as day that system one is making decisions. And you are likely seeing this trade as a battle. That's your cue to pause, get system two involved and try and exert some oversight to your behavior. And to help with this, avoid trading when you're stressed, tired or distracted in any way. You wouldn't trade while intoxicated with drugs like alcohol, but you can easily be intoxicated unknowingly with with stress hormones and adrenaline. And they will make you even more defensive and aggressive than normal. Again making you more vulnerable to system one taking over completely. The final video, number 12 in this course, deals in detail with the biology of trading and the physical steps you can take to instantly improve your performance. So we'll cover that in a lot of detail then. Now let's move on to the closely related factor, the need to be right. As I said in the last lesson, I separate out the need to win from the need to be right. Because the need to be right doesn't always have the same acute, aggressive or fearful physical symptoms. It can feel a lot more intellectual or analytical. It's not a fight as such, it's not a physical threat, more of a threat to one's self respect status. And it is your status sub self that is online influencing your decisions. You've got to remember that trading is a probabilistic activity. When a weather Forecast predicts a 70% chance of ring, when it doesn't ring, it's not correct to say that the forecast was wrong. It predicted a 30% chance of no ring and that's the way it went today. If it rains or not, the forecast wasn't wrong because it's working in probabilities and trading is the same. If you ever find yourself in a trade that correctly follows your system rules and you begin to feel like you were wrong, you are not thinking probabilistically and you are likely being influenced by system one and the need to be right. Trade outcomes do not prove that you were right or wrong. Now the need to be proved right is usually comes after a feeling of certainty. If you enter a trade with a lot of conviction or feeling of certainty, perhaps because of the depth of your market analysis or multiple indicators all saying the same thing, so that you feel exceptionally confident that this is a high probability, then that should Be a huge warning sign to you. Certainty is not compatible with probabilistic thinking. Your strategy indicates probability, never certainty what is likely to happen, not what will happen. The dictionary definition of certainty is something that cannot be dated and it should be fairly obvious. This type of thinking has no place in trading. The trouble is, the need for certainty is again hardwired into us. It was useful for our ancestors to reach social, political and and economic goals. Certainty projects confidence. It can help acquire status a mate. It can assist with staying motivated in complex and unpredictable environments. It's a very comfortable feeling for humans to feel certain about things. We like being certain. We feel extreme discomfort when uncertainty creeps in. So we will try to remove that discomfort. The creators of some trading systems and indicators are extremely good at exploiting this. They exploit both our difficulty with probabilistic thinking and the comfort that the removal of doubt brings. And that's why they emphasize terminology related to high probability, accuracy and prediction. They know that we all crave certainty now. Conviction can also come from overconfidence. Being confident and believing in our own abilities is a survival trick. If we weren't confident that we could fight off a predator, we wouldn't even try and we would be guaranteed not to survive. System one knows that our best chance of survival is to be confident enough to take action even in the face of terrible odds. As such, traders are naturally vulnerable to have overconfidence in their own amalasis scales and their indicators. If you're in illusion trade after entering with confidence and a sense of certainty, you are much more likely to move your stop, loss and override your exit rules. After all, you're confident which direction the trade is going to go, so it makes sense to move the stop. In light of that confidence, it's worth quickly mentioning before we move on that if you do move your stop and the trade does eventually come back into profit, you're even more likely than ever to to then take profit early. As we talked in the last video, the pain and uncertainty of holding onto that losing trade, followed by the relief of being proved right. It's far too powerful to allow the uncertainty to continue by letting it run. Okay, now let's go back to something even more fundamental. Our attitude to risk taking in a loss. You already know from my previous videos that when we're ahead and winning, we are risk averse. We when we're behind and losing, we are risk seeking. This risk seeking attitude underpins everything that we do when we're managing losing trades. Prospect theory shows that losses cause A disproportionate amount of pain and discomfort. And System one will encourage risk taking behavior to try and recover and move away from that pain. Remember the example of the sports themes, making riskier plays when they're behind to try and make a comeback, System one becomes optimistic and your memory recall prioritizes remembering all the times that taking risks paid off. It's no coincidence, but on the whole, casinos are full of people on low incomes or who have severe debt. Here in the uk, sport betting companies take advantage of this by deliberately placing betting shops in deprived areas, ruthlessly exploiting this deep psychological drive. Betting shops are always in poor neighborhoods, not affluent ones. To put it bluntly, losers take more risks. But when I talk about being a loser, it's subjective. Feeling like you're in a losing position is simply the difference between what you expect and the position that you're actually in. Intriguing. If you're expecting to win, but the position is losing, System one will trigger risk seeking behavior. As with everything else, there's no point getting frustrated or thinking that there's something wrong with you. When you can't stick to your trading system and you do end up moving your stops. This is completely rational behavior from a survival point of view and you are hardwired to do this. Taking on risk when you're losing is a great strategy in normal life, and moving your stocks or otherwise leaving your losing position open is taking on more risk. You're behaving normally, just not so good for trading. And the problem is compounded in trading because sometimes it works and when it does, the memory of it will be stored more vividly. And the next time you're in a losing trade, you're going to be encouraged to take even more risk. Again, like all System one pushes, this can be very subtle and it always feels like it's the correct logical course of action. Once again, knowledge of what is going on and self awareness is critical. Whenever you are in a losing trait, regardless of how you feel, you should assume that your risk appetite is now elevated. In a losing position, you will consider doing things that you would never normally consider. If system one thinks that a loss is possible, it will make you think that you are far more capable than you really are. It will disregard probabilistic thinking and turn you from a trader into a gambler in a single heartbeat. Let me just reiterate, this is a fantastic survival mechanism and you don't want to get rid of it. It's just maladaptive for trading and you need increased awareness and oversight to keep it in check. Okay, let's tackle the last of our familiar topics and revisit mental accounting. As I explained in the last video, it's highly likely you are unknowingly keeping tabs on all kinds of mental accounts like running totals for wins versus losses for the day, week or month. And if these are referenced whilst managing open losing trades, then there's a real possibility that your trading decisions will be effective. They'll put pressure on you to override your trading system. For example, if you're wondering whether or not to close a losing position whilst referring to your mental totals of your wins and losses for the day or week, it's highly likely that you're about to operate outside of your trading parameters. Obviously, your trading system doesn't say to alter the trade management depending on whether you've had a good or a bad week so far. But that's exactly what you'll do if you've just been inadvertently thinking about one of these mental accounts. And mental accounting and attitudes to risk can work together. Remember, in a loss you have elevated risk appetite. So let's say that you're trading on a Friday and you're in a losing trade, but you've been keeping a mental account and you're in an above average profit for the week as a whole. That may make you much more likely to engage in risk taking behavior with the excuse that you can use some of the excess profit to justify moving your stock to give this loss a chance to turn around and recover. You say something like, hey, I've got spare money this week so I can use that to take a punt on this last trade of the week. But just as easily, if you've taken more losses than normal in a week, you can use that as an excuse to justify your risk taking behavior to leave this trade open to try and recover those excess losses. All of these decisions are being driven by by an arbitrary mental account tally of recent trade outcomes. System one is fooling you into thinking that you've weighed things up logically, when really it's just a deep urge to engage in risk taking. From a survival standpoint, it goes without saying that mental accounts should not be used to decide how you exit a trade. That decision should be governed by your trading strategy. But of course the reason traders do fall back on mental accounting is is because it's highly convincing. It's a powerful system, one process that feels intuitive, logical, mathematical and evidence based. It feels right and beginner or less self aware traders will just go along with it without thinking Experienced traders haven't managed to turn this off. That's impossible. But they have learned not to allow it to inform or guide their individual trading decisions. Exiting a trade or should always be based on what your system says is relevant to that specific individual trade, not a running total of what has happened before. What has happened in the past does not change or influence what will happen next. Not in trading, anyway. Trading is a strictly probabilistic activity. Acting on running totals can make us vulnerable to what psychologists call the gambler's fallacy, the mistaken belief that if something happens more frequently than normal during some period, it will happen less frequently in the future, or that if something happens less frequently than normal during some period, it will happen more frequently in the future. In trading terms, it describes our intuitive sense that if the last six trades were losses, the next one is more likely to be a winner. It was originally called the Monte Carlo Fallacy after a game of roulette at the Monte Carlo Casino in 1913, when the ball landed on black 26 times in a row. Gamblers then lost millions because as that streak continued, they falsely believed that reds were now more likely next and in high numbers to rebalance the randomness. Now, Lesson seven and eight in this course are dedicated to probability because it is the most important concept for trading success. But for now, just remember that mental accounting feeds this dangerous gambler's fallacy. Okay, now let's look at the endowment effect. In lesson two, I explained how humans create tight bonds with the things that we own. Like tools we have to in a scarce environment. It motivated us to look after and protect the items that were essential for our survival. And in lesson three, we discussed how behavioral economists discovered that those tight bonds translate into enhanced valuations of the things that we own. We automatically place more value on the things that we own. Think back to the Muggs experiment. This effect is another deep system one mechanism. A traditional or a rational economist would say that as soon as something has no utility, we would simply sell it or get rid of it. But we know that doesn't happen, and instead we fill storage containers or our house fills up with clutter. The issue in trading is that once you buy into a stock or an asset, unless you've updated your system one, it will automatically assume ownership, and that immediately, albeit discreetly, means you will have difficulty letting it go for a loss. System one makes it painful for you to let go of what it thinks is you own. You can see the same issue when entrepreneurs become reluctant to give away more than a certain percentage of their company when they're looking for investment. For the rookie entrepreneur, they would prefer to hold 80% of a valueless company than 10% of a multimillion dollar company. They get hung up on the ownership and then end up never getting rich. And the reason this is such a problem is because it's not that we Simply add a 20% monetary value to something. It's. It's an emotional bond which is far more powerful. The old teddy bear you had as a child was priceless. So in this context, the fact that the stock or currency is falling and nearing your stop. Loss. The feeling of loss is amplified emotionally because ownership of anything creates satisfaction in its own right. And to lose it or let it go removes that satisfaction. This is all chemically driven behind the scenes and without your normal awareness. It. It's kept your ancestors alive, but it's maladaptive and it affects your ability to let go of losing trade positions. It's also compounded by a form of mental accounting. The value we place on something is at least the price we paid for it, plus the added value simply from ownership. Without awareness of what is going on below the surface, System 1 will quickly recruit System 2 to provide some intellectual and rational reasons for why you're holding on to a loser. This might seem like a slight effect, especially as it isn't talked about very much as a cause of holding on to losers. But on top of everything else that we've talked about, the endangent effect could easily be the thing that pushes you over the edge and convinces you to hold on to the trade. And likewise with these last two factors. So now let's talk about keeping options open. System one really prefers to keep its options open as much as possible. As I pointed out in lesson two, System one doesn't like uncertainty, so it will try to delay irreversible decisions until such time that probabilistic thinking is removed. And we know beyond any reasonable doubt that what we're doing is the right decision. You can probably think of a time that you've hesitated in making a decision and and you've tried to do more research or gather and assess more information to be sure that you are doing the right thing. But that might be possible with decisions like buying a new car, for instance. It's slow, it's laborious, but it is technically possible to gather all the facts to allow an informed and correct choice. Intriguing. That's impossible. There's a mere infinite amount of data in an information to analyze, and it's changing every second. Your system dictates how and when you're getting and out of a trade based off probabilities. It doesn't say if the trade goes against you. Keep it open until you're absolutely certain it will reverse and come back. And it doesn't say that because you can never be certain. The illusion, of course, is that moving or ignoring your stop feels like keeping your options open and delay in committing to an irreversible decision. But that is still a decision, albeit a passive one. It's worth looking at this tendency in your broader life. When and where do you try and delay a decision to try and keep your options open? And when you do make a decision, do you only connect to things you know you can reverse out of? This can present itself in quite a subtle way in trading. It's actually glamorized in many ways. When people talk about trading their way out of a position. Rather than take the loss and close out, you could average in scale, in or out, pyramid in or out, add more at the pullbacks, or even hedge with positions in other markets, take out options or futures contracts. There's any number of ways that appear to be clever and skillful and tactical methods to turn your loser around. But all any of that is really doing is is trying to keep your options open as a way of delaying making a committed decision that is irreversible. It's a trick of the mind. It's a desire to wait for more certainty. But if you want to be a trader, you have to make decisions that you can never be certain about. Now, lastly, let's talk about the issue of the sunk cost fallacy. Let's suppose that two avid sports fans plan to travel 40 miles to see a basketball game. One of them paid for his ticket and the other was on his way to purchase a ticket when he got one free from a friend. Then, on the night of the game, a blizzard strikes. Which one of them is more likely to brave the blizzard to go and see the game? Obviously, the one that paid for the ticket, he's the one who exchanged money for it. So to not go would feel like the money was wasted. What about if you paid for a very expensive bottle of wine, but after you open it, you. You find you don't really like the taste or you're just simply not enjoying it. Given that you have the memory of the cost that you paid, you're far more likely to finish it even though you're not really enjoying it. It would be more painful to just leave it. We've all done something like this and maybe even joke that. Look, we paid for it. So we're determined to get the most out of this. So a sunk cost is defined as a cost that's already been incurred and cannot be reversed. And if that's the case, rationally speaking, at least it should have no further part in weighing up any part of the decision. Spock would stay home instead of braving the blizzard, and he wouldn't drink the wine if he didn't like the taste. The irretrievable cost is irrelevant. But system one feels pain, in pain for anything. From its perspective. You have parted with some of your valuable resources. The are important to your survival in exchange for something else. So it's expecting something else in return. When you pay the price to get into a trade system one is expecting you to get something back. You can see why it might be difficult to walk away from a losing trade system one wants what it paid for. Classical economists argue that irreversible costs are not taken into account when making rational trading decisions. They're right, but system one is making this decision, not system two. So when you trade, you need awareness of this tendency and you need to manage the way you think. The amount you're willing to lose on a trade should be considered a sunk cost from the outset. You've paid, the money is no longer yours. And whether you get anything in return is irrelevant and should not alter how you exit the position. I mentioned in the last lesson a psychological trick that I use to help dart against priming for taking profit early. But it also helps with this. When I enter a trade, I don't look at the entry level as my starting point. I look at my stop loss level. Maybe the stop loss is $1,000 for me. I paid that and it's out of my account the instant I enter the trade. That is the cost to participate in the market. It's no different to paying for a bottle of wine. And that way I have no problem closing that trade the instant it reaches my stop loss. I can walk away effortlessly because it's an already realized cost, as opposed to only a potential loss that I hope doesn't happen, which is how most people view their trades. And the added benefit is if for whatever reason, I can trail the stop up, even if it's still behind my entry level. For me, that's a reward. I've gained something. I'm now getting something back, which satisfies my system one desire to see a return for the cost. A losing trade can still feel like a reward and not at all Painful for me. It's a simple trick, but it easily subdues System 1's default mode. Okay, so viz. The seven maladaptive System 1 mechanisms that get you to hold on to losing trades instead of cutting them. Hopefully you can now better understand why the seemingly obvious and simple advice to just cut your losses is so hard to follow. It's like saying just be happy or just lose weight. It's more complicated than that, but not so complicated that it can't be rectified, understood and countered with good. System two awareness and oversight. It's just about understanding these mechanisms and and then being aware of how they affect you so you can override the urges. Successful trading is about checking, playing devil's advocate, noticing and deciphering. All of these urges, pushes and nudges that System one is constantly bombarding us with. And remember, System one is far more powerful and much faster in forming judgments than System two. So those urges have a head start. In this case, a head start urging us to leave the trade open and not take the loss. And anything coming from System one will always feel right. The pushes we get are highly convincing. What we have to do is ask ourselves exactly what is driving the urge. Because you only get the answers to the questions that you ask. That might sound obvious, but if you don't ask the right questions habitually, then you'll just keep going with whatever system one is telling you to do. And system one is maladaptive to trading. So ask yourself, is this urge to keep the trade open or not close it? Driven by the need to win? Does it feel like a battle or a fight? Are you physically pumped up? Does it feel like there's someone on the other side that you're up against? Or does it feel like that you were certain that this was going to be a winning trade or go in that certain direction and you don't want to be proved wrong? Maybe you feel you have nothing to lose. Are you now succumbing to the increased risk appetite that we've talked about? Do you feel more optimistic about a reversal in your favor? Is your reluctance to cut the trade underpinned by a general sense that by not closing the trade, you're somehow keeping your options open, waiting for more information before deciding what to do? All of these are are warning signs that you are operating from System one instead of System two? But just be aware, asking these questions isn't going to give you the right answer immediately. It is going to take you a little while before you're even able to notice what these urges are because they communicated to you via feelings, emotions and physical sensations, and in themselves may not be obvious for you to recognize if you've never paid attention in your trading before. But the closer you pay attention and the more you ask questions, the easier this will become, regardless of how uncomfortable it may feel. To start with, trading is about becoming comfortable with discomfort. And what I mean by that is these urges and pushes are uncomfortable. That's why you act upon them, because you want to remove the uncomfortable feeling. Feeling hungry is uncomfortable, so you eat to remove the discomfort. So don't expect this to be an entirely pleasant process. In the short gym, no one said mastering trading was easy. System one does not want to be questioned or overruled. It wants you to act now, without question, at least until it learns or realizes that being overruled sometimes means that you are making much more money. Then it accepts the need to be updated. And it does because Updated. Okay, as usual. Here's a quick summary slide of what we've covered. If you want to pause the video and make some notes, I recommend you do. And here's another quote that I want to give you that I think perfectly encapsulates this lesson from the famous William o'. Neill. It not only reminds us that holding on to losing positions is a common and dangerous trading mistake, it reveals his technique for how to deal with with the system one urges that we've examined today. The next video in this course is looking at trading frequency, which is in simple terms the issue of overtrading and under trading. Don't miss that if you've ever been an impulsive trader jumping into too many trades, or if you've ever hesitated and found yourself sitting on the sidelines. So I'll see you there.