Focus On The Loss, Not The Profit

As a new trader, my only focus was finding breakout stocks. I collected every book on technical analysis that I could find for half price on Amazon, and matched those patterns to the flashiest stocks. If the stock I was considering had a good setup, I took the trade. If it had an even better setup, I risked more on the trade.

But after an entire year, I hadn’t made a dime.

I was what Trading in the Zone refers to as a “boom and buster.” My account balance made the same highs and lows, over and over, like a roller coaster. I wasn’t making progress.

The Evolution of a Profitable Trader

Breaking even after trying everything humanly possible to turn a profit is more than frustrating, it’s depressing. My account would rise slowly over several months only to be completed erased in a single day — sometimes a single hour. I lost friendships. I gained weight. I was just about one inch from giving up, almost every day.

Losses and Lessons

It also didn’t help to know the odds were completely stacked against me. Almost 93% of active traders quit after 5 years. This is twice the rate of failed restaurant businesses. It’s particularly tough because a financial loss is a compounded problem. What I hadn’t realized is that to break even after just a 5% loss, I’d need to make 5.3% on my next trade just to recoup the initial dollar loss.

It was just plain, harsh math.

Reason being, after a loss, you now have less capital to work with, so it will take even more profit just to get back to where you started. It’s financial compounding in reverse.

Position Sizing and Losses

Position sizing: Get comfortable with risk

The main reason for my boom-and-bust equity curve wasn’t poor trade selection. It was poor position sizing.
It seems counterintuitive. When you’re deep in that hole, you want to risk more, you need to risk more. No, actually. You don’t. Proper position sizing should always reflect a sustainable loss, not your desired profit. I made it my new mantra: Winners anticipate loss. Losers anticipate profits.

The formula for position-sizing is actually quite simple, almost more art than science.

Position Size Formula:

Dollar Risk Amount / (Buy Price – Stop Loss Price) = Number of Shares to Buy

The Dollar Risk Amount requires you to come up with a specific dollar amount that you would feel comfortable losing on this trade. It’s weird to think about losing before we even get the trade on, but bear with me.

Your dollar risk amount will be different from anyone else, even someone with the same account balance. People have different comfort levels with loss because we actually experience loss differently. I’ve seen one trader throw up when he lost $200, and another was unfazed, telling memorable stories as he sat on several $5,000 unrealized losses.

Over time, you will come to understand what feels right for you. William O’Neil used to tell his portfolio managers “risk down to the sleeping point.” In other words, risk only what you can stand to lose and still fall asleep at night.

The thing is, accepting loss is a part of the game. Every trader takes losses, we just anticipate and experience them differently. You need to change the way you experience loss. It’s not the end of the world. It’s part of it. Just stay solvent.

Whatever amount you choose, remember to be consistent in your execution, but remain flexible to change as your account balance moves (up or down). I like to risk 1% of my total account balance on most trades. In strong, up-trending markets, I’ll risk up to 1.25%. In choppy or corrective markets, I usually stay in cash or go short using 0.50-0.75% of my total account balance. As my balance grows, my 1% risk will reflect a proportionally larger dollar risk, and if my balance declines, it will be proportionally smaller. This keeps my risk in check.

Let’s say you have $20,000 cash in a trading account and you feel okay losing 1% of your account balance ($200) on each trade. You’ve also identified three positions you would like to open: FB, HQY, and X.

Now, you’re still going to risk the same amount on these trades, even though nothing could be more different about these stocks (separate sectors, price per share, volume profiles, etc.).

The biggest difference between these trades will be their stop loss price (and therefore % loss per trade), but your dollar loss of $200 will be the same.

After determining your stop loss prices (a whole separate topic for another day), you should then calculate the number of appropriate number of shares to buy.

For this example let’s say: 

FB price is $201.74, with a stop loss of $180

HQY price is $80.63, with a stop loss of $78

X price is $36.91, with a stop loss of $35

(Quick Note: If anyone tells you not to use a stop loss, they’re obviously expecting only good things to happen in the market, and you should wish them good luck. One day down the road, maybe tomorrow, maybe next month, they’ll take a catastrophic loss on that trade and finally, say to you “I should’ve used a stop,” and you’ll say “Yep,” and that’ll be the end of that conversation.)

Now use the above Position Size Formula.

Facebook (FB):

$200 / $201.74 – $180 = $200 / $21.74 = 9.19 shares, or 9 shares of FB

HealthEquity (HQY):

$200 / $80.63 – $78 = $200 / $2.63 = 76.05 shares, or 76 shares of HQY

United States Steel Corporation (X):

$200 / $36.91 – $35 = $200 / $1.91 = 104.71 shares, or 104 shares of X

Our position sizes now should look like this:

9 shares of FB at $201.74 = $1,815.66

76 shares of HQY at $80.63 = $6,127.88

104 shares of X at $36.91 = $3,838.64

Total invested: $11,782.18

Cash remaining:  $8,217.82

Account Balance: $20,000.00

Proper position sizing should always reflect a sustainable loss, not your desired profit. Click To Tweet

These are appropriate position sizes for this account size. No matter what happens to your positions, you will not lose more than $200 on any of these trades. The absolute worst case scenario is that you will lose $600 total.

Keeping losses predefined in this way keeps me sane, solvent, and sleeping. It also makes me profitable over time. Assuming I’d picked strong trade setups, I can still expect that probably 1-2 of these positions will hit my stop, but the other positions will move in my favor. And as I “let my runners run,” the profits from those winners will almost always outweigh any incurred loss.

I finally got out of my 70% hole using this strategy. It didn’t happen overnight, but it happened. Now my compounding problem is working in my favor. Take care of your losses, and the profits will take care of themselves.

Give it a shot. Let me know how it goes. And have a good night’s sleep.

Winners anticipate loss. Losers anticipate profits. Click To Tweet
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June 24, 2018