Psychologically, this makes sense, as it is human nature to feel good after winning and to feel bad after losing. Furthermore, losses feel worse than gains feel good, to the point where studies have shown that it takes about 2.5 wins to offset the emotional pain of 1 loss. Thus trading tends to be a negative sum game emotionally.
But like I've said before, when it comes to trading, what comes to mind instinctively is often the incorrect thing to do. What top traders realize is that it is not how accurate your trades are, but how much you make when you win, and how little you give back when you lose.
In Jack Schwager's excellent book, The New Market Wizards
trend following trader William Eckhardt was quoted as saying:...The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.
To help solidify the concept of how accuracy is not required for successful trading, let's go through an example. The following trade is a trade I did with real money last summer that resulted in a profit of approximately 76%:
On August 8th, this stock was identified by one of my scans as a potential short candidate. I knew nothing about the fundamentals of this company, but I did know that the stock was in a downtrend, so I took a short position at $15.00 a share.
Immediately after the trade was filled, I placed a buy stop at the level shown by the dashed line in the chart above. This step is essential for keeping all loses acceptably small in the event the trade does not work out (which happens often).
After about 5 months, here is how the was the trading:
I covered the short position on January 5th, 2009 after the stock rose above its 50 day moving average. The decision to cover caused me no consternation, as I was simply following my predetermined rule.Now, to be clear, this type of trade is not a typical trade for me, and I am not some sort of genius for picking this stock. A profit of this magnitude may happen 5% of the time, but they do happen, and when they do, they cover the cost of all your small losses and more.
