The One Investing Lesson They Don’t Want You to Learn

In trading and investing, as with any business you’re in, you want to turn a profit. When things are going great and profits are coming in, the business is thriving. When things take a turn for the worse, your winners come less frequently, and your profits become smaller.

That’s when things can get really ugly.

But just like in any business – or any part of your life, really – it is how you deal with losses that matters. Your ability to manage your losses is what truly speaks to the profitability of your trading business.

Unfortunately, many investors never learn this… because they don’t want you to learn it.

When I say “they,” I am talking about anyone who benefits when you lose money. That includes market makers, day traders, the big banks, sophisticated trading firms, or anyone on the other side of your trades.

Today, I’m going to show you the best way to deal with losses.

But to do that, you’re going to have to change your whole mindset…

Learning How to Take a Loss

Face facts, traders. Losses WILL happen. There is no 100% winning strategy. The only way to guarantee 100% that you will not take a loss on a trade is to never take a trade.

But you’re determined to learn how to trade and do it successfully. And to succeed in trading, you need to learn how to lose appropriately.

I know that sounds counterintuitive – that learning how to lose will help you to win.

So let me explain…

Once you can accept the fact that losses are going to happen in the normal course of trading, it is then important to work out what percentage loss is acceptable to your portfolio.

Of course, I’m talking about risk. It’s something we talk about often because it’s such an important part of trading. You can’t just go into a trade thinking about your potential gains – you also have to think about your potential losses.

It’s part of any successful trading plan.

I’ve told you this before, but it bears repeating. If you set for yourself a plan where you will risk 50% of your portfolio on your trades and you are willing to risk 100% of that capital on each, two consecutive losses will completely wipe out your trading account. This is not acceptable!

Contrast that wildly irresponsible scenario with one where you decide to only risk 2.5% of your capital per trade. Again, assuming you are willing to accept a 100% loss per trade, it will take 40 consecutive losses to wipe out the account.

If you’ve been reading Power Profit Trades or following along with Money Calendar Alert, then you know I aim to hit 100% gains on all of my options trades, no matter the strategy. You also know I base the trade cost/risk at no more than 2% of a theoretical $25,000 account, or no more than $500 cost/max risk on each trade.

Of course, your risk profile could be a little different – you might only be comfortable risking 1% on each trade. But as long as you know the risk ahead of time and are comfortable making your trades, you’re headed in the right direction.

Trading with a Business Mindset

Thinking of your trading as a business is important to your success. It allows you to separate yourself as a person from yourself as a trader, and can help in eliminating emotional decisions from your trade plan.

It is not unwise to treat your trades as your inventory. Just like a store has inventory it needs to bring in and then sell, your option trades constitute your inventory because your aim is to sell each option for more than you paid.

You need to get inventory in and turn it around, sell it preferably at a profit. Consider the inventory that does not close out profitably as “shrink.”

Shrink is the term businesses use to describe loss of inventory, and many businesses have a pre-determined shrink amount calculated into their P/L models. It can be attributed to employee theft, shoplifting, administrative error, vendor fraud, damaged goods, or any other factor that contributes to a loss of inventory. Whatever the cause, it’s simply a cost of doing business.

So in your trading business, you have to ask yourself: What is your pre-determined shrink amount? What is the level of loss you’re comfortable with as a cost of doing business? Is it 2% per trade? A specific dollar amount? Or are you more comfortable using a stop loss to lower your risk?

Five Rules for Taking Losses

Before you begin your trading business, you must determine how much you’re willing to lose on each trade, and how to handle those losses when the inevitably occur. Now, many of you have already started trading, but it is not too late to incorporate these five simple rules into your overall trading strategy.

  1. Build a solid plan for each trade to measure your risks. Take emotion out of the equation.
  2. Losses are part of the process, and knowing when to take losses is important. Your ability to take losses quickly is a great asset to your trading.
  3. Not taking losses when indicated is dangerous. Exit your losing trades when your trade plan requires you to do so.
  4. Riding losing trades for too long in hopes that they’ll turn around usually results in larger losses.
  5. If you use stop losses, stick with them throughout your trade – It’s usually not a good idea to change your stops to avoid a loss.

Determine the loss amount per trade your account can bear. Adhere to it with a discipline that allows you to stay the course. That will go a long way to preserving your capital.

Capital Preservation is key. The market makers, day traders, and big banks are all counting on you to lose as much money as possible. The better you preserve your capital, the more profitable your trading business will become.

Here’s your trading lesson summary:

As a trader, how you deal with losses is incredibly important. Your ability to manage your losses will help you preserve capital and become a profitable trader. Here are a few things to keep in mind:

  1. Think of your trading as a business. This helps you avoid emotional decision-making.
  2. Determine your risk – how much you’re willing to lose on each trade (even if it looks like a “sure thing”).
  3. Integrate your risk into your trade plan and adhere to your plan no matter what, whether you’re risking 2% per trade or $500 per trade, or using stop losses.
  4. Remember that capital preservation is always your most important goal.

Good Trading,

Tom Gentile

4 Responses to “The One Investing Lesson They Don’t Want You to Learn”

  1. Great instructions about handling the inherent risk, and keeping your losses within a pre-determined amount. I like the comparison of losses in certain trades to the “shrink” factor in a store’s operations.. It’s inevitable–you just need to have a plan to limit it.

  2. Gianluca Peviani

    Hello Tom,
    thanks for your precious suggestions. My portfolio is divided 1/3 equities and 1/3 obligations. Do you think that your rules in the article apply the same way for actions and obligations? or do you suggest a different approach for obligations?
    thanks in advance for your answer
    best regards,

  3. Thanks for the comments… as for the shrink factor, I did a period of time in retail while going to college… so it was an easy analogy when you think about it as a business would.

    Muscat, Risk vs Reward is really tough when applying it to a stock, but to an option or more importantly a spread it can be calculated… So its the percentage of your maximum risk to your maximum reward. For instance, we just put on a Money Calendar Bearish trade in SHLD earlier this week involving puts. We bought the November 27th, 23 puts for 2 points or less, and I expect SHLD to trade to 19 within the next week. In fact since our publication, SHLD has dropped from 22.50 to 19.82, not much but a lot when you look at the percentage drop. Anyway we can calculate the risk to reward based on a target price of 19. The risk would be what you paid for the put, in this case even though the limit was 2, so thats our risk. If the target is 19, the options should be worth 4, so the risk reward is a 1-1. Risking 2 to make 2. Pretty easy when you think about it.

    Finally on the portfolio comment. Thats one I cannot answer for you because each of us is different. As a smart trader, I do not have all my eggs in options, in fact options are just a portion of my portfolio, that changes over time. But your right to think about this, and how it affects your overall portfolio GLP. An advisor might be the best person to give you specific advice on your own portfolio.

    Have a great weekend!

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