With the professional football season heading towards the playoffs, I thought it would be fitting to highlight an important anology between trading and sports. All great coaches know that it takes great offense as well as great defense to be champions. Did you know the same is true in trading? We've all worked hard at finding trades that generate gains (that's the offense), but what happens when things start working against us? Traders need to learn to contain adversity. In other words, traders have to learn to defend themselves from losses.
Most investors think that professional traders win a lot and lose very infrequently. Nothing could be further from the truth. Many pros may have winning percentages barely better than 50%, yet they still make a lot of money. One key factor that separates the pros from the amateurs is that the pros lose small while the amateurs let losses get out of control. How you handle losing trades psychologically is critical to your ability to succeed in the markets. Losing properly (by losing small and continuing to take your trades) makes winning possible. You have to learning to accept your losses, because if you're not willing to take the chance that a trade could lose a pre-defined amount, you'll be afraid to trade or will be scared out of a good position as soon as you get a small profit. This defeats the goal to score big when you are right. A successful trader's mindset must accept losses as a necessary and beneficial part of the trading process when handled properly.

Here are several lessons I've learned over the years in the art of losing small:

1) Never give in to the temptation to ride your losses, which amounts to saying to yourself: "It will come back." That type of thinking has ruined many traders. In other words, you must have the discipline to always cut your losses or keep them small. This is the main thing that will allow you to stay in the game long enough to become successful.

2) Break-even levels are deadly reference point on losers. Avoid the hoping or praying stage that a loser will come back to breakeven. Define your risk on the entry of a trade, and if that risk level is reached, stop the trade and move on to another name.

3) Don't liquidate a winner to keep a loser. You hear experienced traders talk about winning trades which "finance" losing trades. This mentality is interesting, as it suggests that every trade you carry has a cost associated with it. As a result you want to get the best return on every piece of trading capital you employ. This suggests that you should not only not carry losing positions for very long, but even breakeven positions possess an opportunity cost compared to other winning positions you could enter. Start liquidating not when you are clearly wrong, but when the market is not proving your position right.

4) Never let a profit turn into a loss. After you have a profit of 5% or more on a stock or 25% or more on an option, I like to move my stop loss up to break even to avoid this cardinal sin in trading.

5) Track your Equity Curve to minimize your drawdown. I track the equity curves of my various systems, seeking to make trades which are experiencing positive equity curve trends, which is then overlaid on my market timing models to make sure the trends are likely to continue according to the market timing results which have worked well over time. My philosophy is that it is better to minimize risk by reducing trade frequency in tough times, and then I can get aggressive as the conditions for the models improve.

6) Never average down a losing position. This may be tempting to many traders, as the ego wants so badly to be proven right that it looks appealing to average down your cost. But in reality what you are usually doing is throwing more money at a bad idea. You would be better off to close the losing position and move on, but at least diversify into other ideas instead of risking throwing good money after bad in the same idea.

7) Never buy because the price is "low" or sell short because the price is "high." Good trading is about being a student of market structure, so you want to focus on the pattern of price action as opposed to the absolute price itself. Many traders bet against trends when a stock's price seems extended, and the results are often painful for traders focused solely on the price level relative to where it has recently been.

8) When you are in a losing mood, slow down and step back. Don't rush to place the next trade. When you are winning, stay in the zone. Do not change anything. Do not raise or lower your amount your commit to each trade.

Losing is a topic few traders want to talk about. Successful traders will have strategies to manage their losers to keep their risk low. Loss control must be a part of any thorough trading plan. Make sure you have addressed this topic to keep yourself in the game.