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In a previous article, we explained why traders hold on to positions too long. And to combat this, you need to have a plan as to when to cut your losses.
That is easier said than done.
We understand that we need to cut losses quickly.
Otherwise, the loss can easily become too large for your wins to overcome.
Have you heard of traders who make profits for three months, and then one trade wipes out all those gains?
This is what happens if you don’t cut losses quickly enough.
But what does “quickly” mean exactly?
How do we know when to cut losses?
This is the million-dollar question.
If you can answer this question, then you are golden.
This is a question not only in trading but in life as well.
How long do we stay in a relationship that is not working out?
How long should we stay in a job that we hate?
How long do we keep a car that is constantly breaking down?
You don’t want to cut losses too soon.
And you don’t want to cut losses too late.
If you cut your relationship at the first argument, you will not have any relationships.
When you cut your flowers at the first sign of a brown leaf, then you are not letting your flowers flourish.
If you cut your trade too soon, then you are not letting your potential winning trade play out.
Where is that optimal point to cut losses?
There is no exact answer.
The answer depends on the individual’s personality, past life experiences, and decision process that incorporates many factors.
This is the same with trading.
Let’s look at some examples.
Stock Example
We can start with a simple example of stock traders buying shares of stock.
They might set a stop loss below their purchase price and below what they deemed to be support, as analyzed from the candlestick chart.
They then set a profit target that is 1.5 times that stop loss amount.
This can be a trading plan. It tells you exactly when to cut losses and when to exit the trade for a profit.
Options Example
As an example using options, an iron condor trader may cut losses when the loss is greater than two times the max potential profit.
In options, making an adjustment is the same as cutting losses because an adjustment can be thought of as an exit from the current position and an entry into a new position.
For example, an iron condor trader may make an adjustment when the short strike reaches the 25 delta.
Another iron condor trader may make an adjustment when one of the credit spreads increases in position delta by 7.
The timing of when to make adjustments in an options trade is very important.
It is essentially the same question as “when should you cut your losses.”
These were just simple examples.
In reality, an options trader has many other variables that they need to take into their decision.
They might look at the P&L.
If it is much greater than my normal wins, then that is a consideration to cut the trade.
They look at the Greeks.
The trade might be terminated if they are not in line with expectations.
They look at the days till expiration if there is not much time left, which gives stronger weight for cutting the trade.
They have to look at the position on the risk graph.
It gives an idea of the risk to reward that is left in the trade and whether the trade is still in the optimal profit zone.
An options trader who trades butterflies once told me this is how he sees it.
I’ll paraphrase:
“I have an army of butterflies that I send out to battle. The winners can take care of themselves. What I look for are the butterflies that are struggling and that are getting hurt. My job is to stop the battle and bring them back to home base so that they don’t get too damaged and be able to go fight another day.”
Managing Risks
Others have made the analogy that a trader is essentially a risk manager.
They manage the risks.
On the options risk graph, we can see the max risk of the trade.
But if you know exactly when to cut your losses, your effective max risk is not what is shown on the graph.
Your effective max risk is the point at which you cut your losses.
Perhaps you have read books that say that the most important thing to learn in trading is risk management.
What it boils down to is to not let your losses get too big.
Testing Your Cut Loss Points
Ultimately, it depends on the rules of the trading plan that you have in place.
Once you have a plan as to when to cut trades, you need to put that plan to the test.
To know whether the plan works or not, we can backtest it or back-trade it manually with software such as OptionNet Explorer or Option Vue.
You need to track and log your trades to know whether you are cutting losses quickly enough.
You need to be able to see from your logs how large your losses are in relation to your wins and your win rate.
If, for example, your win rate is 50-50, then you cannot have average losses be greater than the average winning amount.
If your win rate is 80% wins and 20% losses, then your average loss cannot be more than four times your average win.
This is why you need to log your P&L across many trades.
You need to know what is your average win size, what is your average loss size, your win-loss ratio, etc.
FAQs
Why do traders hold on to losses?
They are psychologically hoping that the trade returns to profit (hope is not a strategy).
It can also be due to ego. Or they have so much invested in the trade that they cannot bear to take the loss.
Why is it important not to trade too big?
If you trade too big, you will become more emotional.
Emotions such as hope and ego and the psychological concept of sunk cost fallacy start coming into play.
And this may affect the rationality of the trader to cause them to hold losing trades too long.
If you cannot sleep, sell off your positions until you get to the point where you can sleep.
Some even go as far as to say to trade at a size so small that you don’t care.
Conclusion
I’m reminded of a song by country music artist Kenny Rogers from long ago.
It goes:
“You got to know when to hold ’em, know when to fold ’em, Know when to walk away, and know when to run.”
Obviously, referring to poker, the name of the song is called “The Gambler.” I’m not saying that trading and poker are like gambling.
They are not.
While there is an element of pure chance, there is also the element of skill involved.
It may very well be that the most important skill that traders need to learn to be successful is to know when to cut your losses.
We hope you enjoyed this article on cutting your losses.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
