Wednesday, May 05, 2010

Chasing Losses and Abandoning Profits

With respect to trading, humans are better described as loss averse than as risk averse, Because the pain of a $100 loss far outweighs (between 200% and 500%) the pleasure of a $100 profit, when faced with a situation framed as a probable failure we gamble and when faced with a situation framed as a probable success we quickly take profits. In other words, we neither maximize profits nor minimize losses! This is the normal human condition.
As a result, whatever approach we take to reducing the impact of chased losses or abandoned profits must always allow for some of both. Trying to completely defy human nature is simply pointless and guaranteed to fail!
One approach that I would recommend is to use a form of session trading. Set aside a daily bankroll based on both the number of markets you wish to trade and the maximum number of units you are willing to risk for some minimum profit target. Critically, you must factor in a small percentage for the possibility of chasing losses.