One of the most prominent learning curves and obstacles to overcome in trading is keeping your winners larger than your losers. Having worked among retail traders for a decade now, I’ve observed the tendency for new traders to risk much while securing modest profits. However, for most traders, one of the secrets to taking your trading to the next level is developing a good win percentage on trades, taking strict entry criteria, and employing a healthy risk-to-reward ratio.
Consider this: if you are risking a factor of 1 to earn 1, you need to be successful on 55% of your trades just to cover commissions, data and platform cost, and exchange fees. If you risk a variable of 2 to earn 1, you need 60% winnings to compensate for these costs. This does not even include the higher win percentage needed to generate a livelihood or grow your account.
Also, if you are risking 2 to earn 1, what happens when you go on a four-trade losing streak, which will inevitably occur? At that point, you would have to secure a 90% win percentage over the following several trades just to make up for losses.
On the other hand, if you risk a factor of 1 to earn 2, you can cover your cost with a modest 40% win percentage. Additionally, you will be able to rebound more easily from a losing streak.
Having worked with traders and being one myself, I can attest to the mental and emotional challenges of being patient with winners and impatient with losers. Therefore, this article will approach the concept from a mental and emotional point of view. At the same time, the follow-up article will discuss specific trading logistics that can help you keep winners larger and losers smaller.
Wrap your mind around it!
Sun Tzu says that wars are won or lost in the temple before they are ever fought on the battlefield. When I adapt this to trading, I recognize that successful traders and trading happen not at the charts but in the personal disposition and preparation of the trader. The battlefield of the mind is where it is most crucial to be victorious; otherwise, you’ll never achieve sustainable wins on the charts.
Know why you do it
The first step of transitioning into a pattern of risking less to earn more is approaching it cognitively. For example, you might calculate based on your own trading history and determine if you had increased the profit on winning trades by 25% and decreased the deficit on losing trades by 33%, what kind of impact that would have had on your account.
Amazingly, I’ve encountered many traders over time who don’t believe in utilizing a greater reward than risk ratio. Until you are a believer, you’ll never seize the opportunity. So run your own calculations and see what you come up with.
Plan for success
Once you realize the necessity of taking larger winners while keeping your losers smaller, you need to adapt your trading plan accordingly. This includes looking at charts and identifying spots with strong entries where you can feasibly risk less to employ broader targets. Having a good risk-to-reward ratio is a start, but revolving your entire market outlook around that ratio is the next step.
Become mechanical
Okay, so once you have the correct principles and the right plan in place, the next step is strengthening the implementation of our preparation with discipline.
I get it; we start a trade, and we think we will be successful if we widen our stops and negotiate. Sometimes that works, but many other times, the results are detrimental. Or, we decide to move our limit orders closer, compromising our profit. Again, sometimes that works for the best, but other times, it fails.
If we believe in our planning, we should be confident to take the guesswork out and become mechanical. If you don’t believe enough in your planning, I suggest you go back to the drawing board. However, you can set your target and stop on virtually all trading platforms as an OCO order and let the machine work for you.
Why is it that trading is largely algorithmic and program-based? In part because machines don’t get scared and change their plans! If you must, then you should even walk away while in a trade and let your machine manage it for you.
Regulate emotions
Once your mind is managed, you then face perhaps the most challenging task: managing your emotions. Emotions are not a bad thing; they help direct us in a healthy way. However, mismanaged emotions can often prompt us to think in unhelpful and even harmful ways.
Trading has the potential to bring out the best and worst qualities of a human, and in terms of emotions, it will bring out the worst in us.
So how do you regulate emotions? Good question! There is no one-size solution. However, to reflect on how you may cultivate better emotional management, I’ll list three steps below.
Automate
Yes, I’ve already said this, but I repeat, automate your trading. This doesn’t mean automating every step, but at least the target and risk management. I think most of you will agree that absorbing a reasonable loss is not the worst emotional experience. However, for the majority of traders, the emotional endurance and the process required while a trade is in action are more exhausting. So automate your emotions out of your decision as much as possible. In this case, thinking like a robot can again be a help.
Find your healthy place
This reinforces something I alluded to earlier. Our emotions tend to be more vulnerable during trade management than after a trade is concluded. If it is most helpful to walk away and let your orders work, then do it. Alternatively, others find that keeping a workout machine beside their desk helps keep emotions in check, or even listening to music. Remember, the goal is not to let yourself get in the way of a good risk management plan.
Keep handy notes
This is a trick I personally use, and I know others who have taken the same approach and found it helpful. It may not work for everyone, but for me, it’s crucial. When I write down a trading plan, whether it be risk management, entry criteria, or emotional/mental management, I keep notes on a sticky pad and have them stuck to my monitors.
The result is that I’m reminding myself, sometimes intentionally and other times subconsciously, of my tried and true rules that I can depend on throughout the day. This keeps me disciplined, focused, and my emotions in check.
Sometimes these notes will be simple with one key phrase that will provoke a single memory of when I broke my rules and how bad it felt. This may seem like a petty method, but the value of reinforcement is a superb quality.
Journal your emotions
This is a serious and effective tool. If you have trouble managing your reactions, keep a personal journal of your trading emotions. Record the times of day, the market scenario, the feeling, and the bad habits it generated. Eventually, you can synthesize the journaled material into a better self-understanding of what’s happening to you. Then you can adjust your planning to accommodate your emotional makeup.
These are a few things you might reflect on if you desire to keep your winners larger and losers smaller. If you allow yourself to consider these ideas deeply, I do not doubt that the material conveyed here will be helpful. In the following article, we’ll turn from these more psychological aspects to going over practical tips and looking at chart examples.
Opportunities
First, let’s discuss the existing market opportunities and how they may factor into low-risk and high-reward possibilities.
Scalping
I’ve observed among those in the retail trading world that scalping is a popular technique, especially for new traders. From my perspective, this is because many traders haven’t developed the patience to hold for longer durations.
While I believe in technical analysis, I still find that much of the market movement is random. This means that there is no significant underlying reason to expect the market to move in one direction or another, except on some occasions. Let me clarify: while there may be some technical reason to expect a move, chart analysis is not an exact science as many look at charts differently.
Furthermore, I’m not sure that the big money that moves markets is focused on what a micro charting timeframe suggests. In other words, if you are scalping, then you must do everything possible to enhance your edge.
With scalping timeframes, let’s say trades you expect to hold anywhere from a minute to ten minutes are very random. I find it challenging to have tighter stops and wider targets on these frames. If you are a scalper and struggle to keep your winners larger than your losers, you may need to widen your approach, give your trades more time, and use a different method. On the other hand, if you are scalping with low risk and high reward, then, by all means, carry on.
Breakouts
When a market breaks out of a confined pattern, it often provides traders with intrigue. It appears momentum and a new trend are developing. These ingredients would often present a good chance to enter with low risk and high reward, and this often works. However, breakouts are tricky. Many times, there will be a breakout, but then the market will reverse and retest the breakout area. So, if you want to trade a breakout, there are a couple of important factors to consider.
One is the time of day. I expect that most of you are day traders and know the importance of timing. If a market experiences a breakout during a slow part of the day with less activity, I find it less appealing to jump in. However, if it is early in the day when momentum can carry the trend further, then it’s much more worth considering. Secondly, volume is also a tell. If a market is breaking out on good volume, then it’s worthwhile to pay much more attention to it. However, I’d generally prefer to wait for the retest if it is on low volume.
Retests
Naturally, one might expect that the more patient the trader is, the more precise and successful trade entries are, and this is true. Trading a retest is ideal if you want to keep losers small and winners large. This is especially true of a first retreat. Eventually, multiple retests will fail, but the first touch is often the safest.
Retests are best done when trading with the trend. So perhaps a breakout and then a retest of the breakout may offer an excellent opportunity. But there are other ways within a trend, let’s say a bullish trend, there is a pullback to some key level, and then a continuation from that level.
I believe the best chance exists for small losers compared to larger winners in these cases. Additionally, I think your probabilities are better. What you will have is the best of many worlds. On the larger time frame, you are still trading with the broader trend; however, you are setting up for a reversal on the smaller time frame. Catching a reversal typically offers the best chance for a large winner, and when done in conjunction with the dominant trend, it presents significant opportunities.
Reversal
Finally, in this section, I want to address the idea of reversals as a stand-alone. I presume that this method is widely popular. Simply put, calling market highs and lows, tops or bottoms, catching a falling knife, or trying to stop a launching rocket can be risky. This is why it should be done in parallel to a larger trend.
What I’m about to say is especially true when you don’t have any trend in your favor, but you are trying to catch reversals. The chances are, you will have more losing trades than you will winners. Some days you can do alright, but on “trend days,” you’ll be fighting all day and exhaust yourself and your money.
I only advocate trading reversals when you are on the side of a larger trend. If you insist on trading against the proverbial grain and try to catch trend chances and go against momentum, you must use much larger targets than stops. In many scenarios, a 2:1 or 3:1 return on risk is necessary, but if you are trying to catch every falling knife, I suggest at least a 5:1 return on risk. Otherwise, I believe you are risking your longevity.
Trading
In this section, we want to move away from market opportunities to examine some trading methods with larger winners and lower risks.
Keep your risk-to-reward profile fluid
Once traders learn the necessity of utilizing a healthy ratio in terms of return on risk, one of their mistakes is becoming too rigid. One of the unheralded ways to take your trading to the next level is by assessing each trade as to its potential. Some opportunities feature a 2:1 return on risk; other setups will merit a 5:1 type of chance. The key is to be fluid, allowing your market to dictate this. For example, during volatile times, a 5:1 can work, but in slow periods, 2:1 may be much better.
Where to set targets
One way to set your targets is at previous levels. For instance, if you are buying, set a target at the previous resistance. You may want to scale out halfway there and then more at the resistance level and hold a runner position if resistance breaks. You can look at a chart and tell where momentum frequently ceases, and markets begin to slow down and potentially reverse. Then, based on where your target is, you’ll know how to manage your stop to ensure a proper risk-to-reward ratio.
Another way to set targets is by using standard deviations. I like to plot a 20-period moving average Bollinger Bands on my chart, with 1, 2, and 3 standard deviations. If I buy at -1 standard deviation, as an example, then I’ll likely target +1 for my first scale, +2 for another scale, and +3 for an additional scale.
Simply noted, you can plan a responsible stop when you know your target(s).
Where to set stops
There are some instances in which your target is less clear. In that case, and in some other scenarios, it may be appropriate to set your stop and then determine how wide your target should be. As an example, let’s say you assess a good stop based on your chart is to risk $200; then you’ll know that this trade should at least target $400 worth of profit.
I often let the charts inform me of where to set my stop. There are also good technical indicators on most charting platforms that provide a helpful detection for stops. For example, let’s say I’m long; it may occur when a market breaks some short-term support. Other factors could include volatility. In a volatile market, if I’m long and a market breaks the previous bar’s low after I enter, I’ll exit. However, I would exercise more flexibility in slower markets, most likely a money stop. In other words, I’ll risk x amount.
Conclusion
This article has examined some practical ways to consider how your trading may incorporate wider targets compared to tighter stops, giving yourself big winners and small losers. These reflections should merely be conversation starters, enabling you to discover what works best according to your trading personality.
