The Five Outcomes of Any Trade

Mar 7, 2007: 10:41 AM CST

When you enter a trade, you expect prices to move in your favor and gain profit from your temporary assumption of risk. The outcome is not always profit, however, and losses can be very frustrating in the market. Even though human nature primes us to put more emphasis on current events (and outcomes), trading success hinges on probabilitstic thinking and creating a positive edge over many trades taken consistently through a proven trading method or system.

Realize that “you are not your trades.” You also are not your system or method. Studying the application of the five mathematical outcomes of any trade can lift your condifence and quell the psychological pain from focusing too much on recent outcomes from your trades.

After you enter a trade, you will experience one of five outcomes when you close that trade:

  1. You will experience a Large Profit
  2. You will experience a Small Profit
  3. You will “scratch” the trade for Break-even
  4. You will experience a Small Loss
  5. You will experience a Large Loss

Obviously, your system should be designed to allow you to capture large profits and small profits with a few break-even trades in there, right? Not in reality.

Realize that you will experiences losses in market speculation, and also realize that market professionals often have “win rates” less than 50% (they lose money on more than half of their total trades). Also realize that traders who have very high win rates (70% or higher) turn out to be break-even traders or losing traders at the end of the month or year.

How can this knowledge be comforting to you? Let’s apply cross-cancellation to the outcomes above.

If you consistently apply a system with good money management and discipline (defined as allowing trades room to run when playing for large targets AND cutting losses before they become large losses), then the following end-of-year result should occur even if you are a trader with a 50% win rate:

  • Small losses will be offset by small profits (leading to break-even results)
  • Break-even trades (scratches) will result in ‘break-even’ results
  • Large losses will be eliminated by proper utilization of stop-losses (excluding rare events such as violent gaps which will occur a few times through the year)

So according to our five outcomes, which one remains?

“You will experience large profits”

The above is a simple, mathematic explanation of probabilistic outcomes of your trades based on your trading system (which should be proven to have a positive edge and expectancy).

If we are left at the end of the year with “large profits,” then we traders with a positive edge should be profitable, right? Right, but that is not the end result in an industry where so many people fail.

People take their profits too early and hold on to losers. This skews the distribution graph negatively and “bleeds” mathematical edge away from the trader. Not only is the trader forfeiting large profits, but he is experiencing large losses that disciplined stop-loss behavior would eliminate.

In a simplistic conclusion, traders must hold on with conviction and play for large profits, and realize that small profits will only be offset by small losses. Large losses still may occur (due to sudden volatility or gaps), but they will be much fewer in frequency and will be offset by corresponding large profits. What will remain is other large profits that may come from a handful of trades, but will set the trader with a positive account over time, be it at the end of the month or the year.

Emotional Caveat: Most of the trades that result in large profits are entered in environments where most traders would not enter. A recent example would be the rampant negativity that we experienced in the 10% market decline of May-June 2006. The market increased 25% following the ‘bottom,’ but the technical and fundamental picture was so negative, that many traders refused to enter. Many times, not only do we ‘pass’ on trades that would have given us large profits, we do not press our edge and hold these trades EVEN IF we enter them.

We tend to trade where we feel comfortable and take our profits far too early. As exemplified above, if you only play for small targets, you can hope for break-even at best. Finding opportunities to play for large targets and use small targets to offset small losses (while guarding against large losses) should create a probability ‘outcome’ edge for success in trading.

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