Money management is crucial in trading. It can be said that seeing the market correctly is only half of the success of trading. If there is no scientific fund management strategy, success will often be missed. Many traders believe in the fund management principle of "limited loss, unlimited profit". However, the fact is just the opposite. They have a completely different mentality when dealing with the profit and loss of foreign exchange positions: stop profit is always easy, stop loss is always too difficult !
1. Inspired by psychological experiments
Why stop profit is always easy, stop loss is always too difficult? The answer comes from human psychology. To understand this question, let's look at a frequently used psychological experiment. Imagine you answer the following questions:
600 people were infected with a deadly disease with the following two drugs available:
(A) 200 lives could be saved.
(B) There is a 1/3 probability that everyone will be cured, and a 2/3 probability that none will be saved.
Which medicine do you choose?
If you choose A, you are sure that you can save 200 people, and if you choose B, you want to bet on how many people can be saved. So the choice was easy: 72% of respondents chose A. Because you dare not bet on how many people you can save.
Here's another question:
600 people were infected with a deadly disease with the following two drugs available:
(A) Certainly killed 400 people.
(B) There is a 1/3 probability that everyone will be cured, and a 2/3 probability that none will be saved.
Would you choose to kill 400 people? No, at least there is still the possibility of saving everyone. Only 22% of people chose A for this question.
This interesting experiment was first designed by Kahneman and Twisky in 1981. In fact, the two problems are exactly the same, but the way of expression is different. The first focuses on gains, while the second focuses on losses. Using this and other similar questions, the two scientists came to the conclusion that people have different attitudes toward gains and losses, and that people are more willing to bet on losses than gains.
Let's see how the above conclusions are applied to the foreign exchange market. Profit and loss is a common thing in investment. Suppose your foreign exchange position has suffered a loss, what should you do? Like most other people, you will bet that one day it will "carry it back (that is, the floating loss becomes a floating profit or the loss is reduced)". Now assume that the foreign exchange position you hold has already made a profit. This time you will not gamble again. Your approach is very simple: stop the profit immediately and take it for granted. This phenomenon of "taking profit is always easy, and stopping loss is always too difficult" violates the principle of "limited loss, unlimited profit". After long-term trading operations, many investors' capital accounts are shrinking day by day. What's even more frightening is that due to one or two big losses that cannot be recovered, the funds are almost in short supply.
2. Explanation of "stop loss is too difficult" by expectation theory
The fact that we place more weight on gains and losses than gains and losses of the same size is called expectations theory. This theory was first put forward by Kahneman and Tversky in 1979 (Kahneman and Tversky, 1979a), which can explain why traders are more willing to take profit than stop loss.
Furthermore, psychologists believe that this phenomenon can also be partially explained by the "regret theory". Statman is an authoritative scholar on regret theory, and he pointed out the obvious facts (see his 1994 article "Tracking Error, Regret, and Asset Allocation Strategies"). According to Statman, we prefer losing bets to winning bets because we are afraid to face the reality of failure. Applying the above theory to the market, we can imagine that by holding on to a position that has already lost money (betting that it can be carried back), we don't have to admit that we made a mistake. After all, the contract held has not yet been closed out, and the loss is only a book loss. Can you say that I have lost money? Under such circumstances, most people prefer to believe that something will happen to reverse the direction of the market, so they tend to stop trading and stand still when losses occur in holding positions.
Shefrin and Statman gave an explanation of why people are reluctant to stop losses in 1985, when they explained it in terms of the stock market. Now we might as well borrow this explanation to the market. In general, people trade for both cognitive and emotional reasons. The reason they trade is that they think they have information when in reality all they have is noise. The reason why they speculate in foreign exchange is also because doing transactions can bring them pride. Making deals brings pride when the decision is right, and regret when the decision is wrong. Investors want to avoid the pain of regret, so they have to hold the losing position in their hands, lest the loss actually happen or be blamed on the critics.
Regret theory is also called "risk aversion". As a typical example of self-protection attitude, it explains why investors "stop losses too hard".
There is another related phenomenon that can explain the expectation theory, which is the so-called "spiritual isolation". The basic reasoning is this: we like to classify unknown quantities and treat them differently, rather than treating them as a whole and optimizing them as a whole. A typical symptom of this phenomenon is to hold on to losing positions, because it is difficult to invest in other more promising asset portfolios because of the occupation of funds. We always try to optimize every investment (which is kind of stupid), even though we know it means losing the total investment opportunity. I once witnessed that a client was locked up for more than three months because of several losses and multiple orders of wheat. In the end, he failed to carry it back and had to admit the loss. Prospective trading opportunities were also missed.
Cognitive dissonance can ultimately explain why "stopping losses is too hard." Closing out a losing position is tantamount to admitting a discrepancy between your perception of the market and the harsh reality of the market.
3. Why "stop profit is always simple"
When the market moves in the same direction as the trader judges, and the position starts to generate floating profits, the situation is very different: the winner has nothing to hide. But winners face another trap: They prefer to think of their success as the result of personal effort rather than luck. Social psychologists call this phenomenon "ego." We are all egotistical, at least on average. The vast majority rated themselves as above average on every single trait of their personality – including driving skills, sense of humor, risk management and life expectancy. For example, when a group of American students were asked about their ability to drive safely, 82% thought they were in the top 30%. What does this mean for investors making money in the futures market? This theory holds that many investors attribute the money they have recently made in the futures market to their investment levels beyond ordinary people. And because they think they have a high level, they operate more frequently, and some even try to catch every fluctuation in the market. Therefore, the reason why they are highly motivated to take profit is mainly due to their personal self-confidence.
Four. Conclusion
Many investors generally have the confusion of "taking profit is always easy, and stopping loss is always too difficult". In fact, this is a weakness of our human nature. To defeat the market, you must first defeat yourself. Profit and loss is a common thing in investment. If you want to make a profit in the market for a long time, you must take a correct view of the profit and loss of investment. This is the prerequisite for establishing a scientific fund management strategy. Before trading, formulate a detailed trading plan, and then strictly implement your trading plan. Don’t stop profit, don’t stop profit casually, and don’t be “soft-hearted” when it’s time to stop loss.
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