How to behave after a loss

In the post on overconfidence, we saw what happens in a trader’s mind after a series of wins. Here we look at the opposite case: what a loss does to the person who suffers it, and how to avoid turning one bad trade into a bad week. In the post on losses and recovery, we saw how heavy a loss is in numbers. Here we see how to behave.

Losing streaks are normal

Even with a good strategy, losses come in series. Suppose each trade had a 50% chance of being a loss and trades were independent of one another. Calculated with the exact method published by the mathematician Mark F. Schilling (The College Mathematics Journal, 1990), the probability that, over 100 trades, there is at least one series of five consecutive losses is about 81%. For a series of six consecutive losses, it is about 55%. Real strategies are different, but the lesson is the same.

A series of losses does not mean that your strategy has stopped working, or that you are not cut out for trading. It simply means that you are trading. The problem is not the series itself, but what you do during it.

Revenge trading

Revenge trading means opening a trade to win back what you have just lost, instead of because your plan has given a signal. It is driven by emotion: you want to feel that the loss never happened. The typical signs are a larger position than usual, a stop-loss that is removed or moved, a trade opened immediately after being stopped out, or a market that you do not normally follow.

As we saw with Prospect Theory and its “reflection effect,” when faced with a loss, people become risk lovers, and this is exactly what happens here. The market does not know that you have lost and does not owe you anything: the next trade has the same odds as any other, but you take it in a worse state of mind.

Two mistakes you already know

After a loss, the wish to win it back also pushes you towards overtrading, that is, too many trades. As we saw in the chapter on the trading plan, setting in advance the maximum number of open trades is exactly what helps you avoid it. And as we saw in the post on the Equity Premium Puzzle, constantly checking your portfolio increases your fears and uncertainties and leads to continuous buying and selling, and spending hours in front of the screen does not bring more money into your account.

The wish to win it back also pushes you to hurry back into the market so as not to miss an opportunity. As we have already seen in the post on rules, do not be hasty. The markets are open every day, and there will always be another opportunity.

What to do

When you feel the urge to win it back, ask yourself only one question: does my trading plan give me a signal? As we have seen, its rules are made of simple yes or no answers. If the answer is not yes, you stay out of the market.

After a loss, especially if it is part of a series, the most useful thing is to stop for a moment. Step away from the screen, and do not trade when you are angry, tired or distracted. A decision made in that state is not a real decision: it is a reaction.

I speak from experience. When I am irritated because I have been stopped out, I leave trading behind for a while. I often go out with my dog or play with him, or I make myself a hot chocolate, and I try to relax my mind and my nerves.

Then, with a cool head, do what your trading plan prescribes when a trade reaches the stop-loss: analyse whether you followed the plan and, if you did not, understand the mistakes you made. A loss within the plan is part of the game. Only mistakes need to be corrected.

Losses are the price of trading. You cannot decide whether you will have them, but you can decide how you behave when they come.