Does your Trading Strategy suffer because of Loss Aversion?

Loss Aversion is so important that Kenny Rogers wrote a song about it. But knowing when to cut your losses (“fold em”) is extremely difficult to do. Especially when you have an emotional tie to the thing you’re trying to cut, in this case, a financial loss.

Likewise, this applies to when a trade is in profit. A common mistake retail traders make is closing a winning trade too early (not knowing when to “hold em”). It is equally difficult to see the profit and not close the trade, fearing the profit will disappear. 

Hence why discipline in trading is such an important attribute to have. Discipline takes time and patience and is often one thing that separates professional traders from retail traders. Discipline can be learned, and careful consideration should be given to the reason you open and close a trade. 

One way traders can remove emotion from their trading is to use algorithms. It is possible to eliminate emotions from trading by coding your strategy and automating its operation. As is discussed in this podcast episode

What does Loss Aversion look like?

The (La) Investible Attribute answers this very question. It allows you to visualise three key areas of each position:

  1. Maximum positive excursion
  2. Maximum negative excursion
  3. The close position in relation to the above two points.

This visualisation allows you to quickly see how disciplined the trader is. A strategy with short red bars can indicate that the strategy quickly cuts losses. A strategy that quickly cuts losses and lets profits run will likely score highly on the (La) Investable Attribute. 

Loss Aversion and Martingale

Another interesting point regarding its use is combining it with the (Rs) Investible Attribute. Low scores in each of these can indicate the underlying strategy is operating a martingale style of trading.

Martingale is a dangerous way of managing risk. It is the process of opening new positions as the price moves negatively against the trader. The more it moves against the trader, the more, and often larger positions, are opened. 

This results in a compounding of risk, which leaves the account exposed to enormous levels of risk. The theory behind a martingale approach is that price will eventually revert to its mean.

So by opening multiple, larger positions, you reduce the distance required to break even. The length of price moves against the trader can’t be defined, and as such, leave the account at greater risk of a margin call

As an investor, always look carefully at the (Rs) and (La) Investible Attributes. If both of these are low, you should take extra care analysing that particular DARWIN. 

Trading Account Analysis

Remember, you can take advantage of Darwinex’s Investible Attributes even if you don’t have a trading account with Darwinex. By creating a free user account, you can link your existing account with your existing broker and analyse its performance using the Darwinex Investible Attributes. 

However, you won’t be eligible to participate in DarwinIA, Darwinex’s monthly prop trading allocation. To do this, you will need to open a Darwinex trading account. If you decide to open a trading account, you can permanently import your existing history from your live account with a different broker. You can find more info on this here

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:

Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

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