There is a “trick” of risk analysis that is used in investment evaluation that you might find really useful in your trading – especially when you are thinking of closing out a position.
Let’s think of each trade you make as an investment. You put a certain amount of money into the market – that is your risk capital – and hope that after a certain time the market will go your way and you will be able to close your trade with a certain return on your investment (ROI). After all, it’s called “investing in the market” for a reason.
The exit is where you make money
Now, since you are doing good trade practice, when you’ve used your strategy to decide to enter the market, your strategy also considers where you’re going to exit the market. If all goes well, you can just trust your strategy – but the market is fickle and can change in ways you don’t anticipate. What should you do?
Some traders take a robotic approach; that they’ve placed their take profit and stop loss, whatever the market does, it’s going to hit one of those limits and that will be the result of the trade. There are are arguments that support that position, but this article is addressed to the people who reevaluate their position once in the market – either to limit their inevitable losses, or to profit more on a trade that is going the right way.
The sunken loss fallacy
A common way of thinking is that people are worried about losing the money they’ve put in the market. This makes sense – if you’ve risked a certain amount of money on a trade, you want it back and some profit as well!
If, however, you think of that money as already gone, then you can have a clearer vision of the market conditions right now. For example: if you bought a pair, but the market then goes the wrong way. You’re down 20 pips. But the market might go back up, and so you are more inclined to hold onto your trade to “get those 20 pips back”, than you would, for example, risk a similar amount of money in a new trade.
See, thinking about the first part of the trade can get into the way of making a rational decision of where the market is going when it comes to the second half of the trade. You can help get around this by analyzing the situation as if those 20 pips are already gone. The market has already moved on – the question you need to be focusing on is where is the market going.
Keep the profit coming
There is a positive side to this, as well. If the market has gone up and you are wondering if you should let it hit the take profit level or keep running to make more money. The only way you can guarantee the profit that you have accumulated so far is if you close your trade right now.
So, more cautious traders might close their trade then and there – they don’t want to risk what they already have. More risky traders might keep it open. But, reasonable traders are likely to look at the accumulated profit in the same way they look at an accumulated loss: it doesn’t impact where the market is going.
The market doesn’t care about how much you are up or down on a trade. Consequently, you shouldn’t think of that when deciding whether or not to leave your trade open (don’t forget to move up your stop loss to lock in the profit so far, of course).
The way to evaluate your exit from a trade is to evaluate the market with the same cool detachment you do when entering a trade. This is further reason why it’s important to remember that every trade has two parts – unless, as mentioned before, you’re are going to stick to rigid levels of take profit and loss.