Intro

Many people want to be successful at trading, yet very few are. So what is the distinguishable factor between successful traders and unsuccessful traders? The key to being successful in trading from a psychological perspective is simple, but the implementation of it remains very difficult as it requires changing your psychological viewpoint when it comes to the goal of trading. Every trader has at some point entered a trade that aligned perfectly with their analysis yet has moved in the wrong direction. Instead of cutting losses, they use confirmation bias to look for reasons that align with their directional view instead of accepting the loss and moving on. This stems from the attachment to winning. 

The Attachment to Winning (Being Right)

We all have a natural inclination to want to win. Nobody likes losing and in trading, many people equate losing to closing a losing trade. This leads to bad habits like holding on to losers for too long or adding on to losing trades, and closing winners too early to grab that quick "victory" even if it goes against your overall trading plan. To change one's psychology to be beneficial for trading, we need to redefine what winning is in the trading environment. Most inexperienced traders would define winning as closing out a profitable trade every single time - a near impossible feat as the market does not take into account your analysis before moving. This can be frustrating but happens often enough to even experienced traders. So, what does it mean to "win" in trading? Ultimately, our goal as traders is to make a profit. This does not mean we have to be profitable every trade, but rather, be profitable in the long run. A trading strategy that only has 30% of winning trades is still an effective strategy if it produces profit in the long run. Someone who has a win rate of 80% could still be losing money from trading. Traders need to shift their mindset from focusing on winning every single trade, and rather focus on being disciplined enough to follow their strategy, accept that losses are part of the game and use risk and money management best practices so they can trade another day and be profitable in the long-term. While this sounds simple, many people still focus on winning the battle and not the war. 

Finite vs. Infinite Games

James P. Carse wrote a book in 1986 called Infinte vs. Finite Games. James was not a trader or a financial professional, yet this book highlights the importance of defining what game us traders are playing, and the psychological approach we need to take in order to "win". Winning has different definitions when it comes to finite and infinite games. A finite game refers to games that we are familiar with - football, baseball, blackjack, chess etc. These games have defined players and observers, fixed rules, and the game eventually ends at a certain point with obvious winners and losers. Infinite games have known and unknown players, no agreed-upon set of rules, players drop out and the game never ends. Examples include starting a business, running a casino, poker, and trading the financial markets. Players in an infinite game should not be focused on winning but rather staying in the game. A good example of this is poker - each hand represents a finite game in the infinite game that is poker where a player can win or lose that hand, but the overall goal here is to not lose all your chips. This mentality can be applied to trading where the traders goal is to stay in the game even when they lose some trades. It is very important for traders to realize that they are players in an infinite game where the goal is to stay in the game and protect your trading account at all costs. When this approach is implemented, it becomes much easier psychologically to place trades with better risk/reward ratios and incorporate good risk and account management practices. 

Golden Rule of Risk Management

Never risk more than 1%-2% of your account on a single trade. That’s the golden rule for risk management. This comes back to the concept of staying in the infinite game - the less risk you take per trade, the more consecutive losses are needed to blow up your account. Smaller losses are also easier to accept and let go of. The problem comes when a trader places a trade risking a large chunk of the account size. In this case, there is even more pressure for the trade to be a winner as the trader simply cannot afford to lose this trade because it would result in the account blowing up. After conducting your analysis and placing the trade, the direction that price moves in is out of the trader's control. By controlling what you can control (how much you risk per trade), you stand a better chance of surviving losing trades and being able to trade another day.

Gains Required to Breakeven after a Loss

When growing your trading account, assuming each trade generates the same percentage return, account growth looks similar to an exponential function. For example, a 5% gain on a $5000 account gives $250 but a 5% gain on a $10000 account gives $500. A larger trading account gives more buying power and therefore a larger dollar return on winning trades. The same logic is applied to drawdowns and the gains required to get back to breakeven. The chart below shows that the relationship between losses incurred in percentages, and how much % gain is required to breakeven is represented as an exponential function. A 10% drawdown only requires an 11% gain to get back to the starting point but a 80% drawdown requires 400%. Again, this highlights why the golden rule of risk management is so important. The less risk per trade, the easier it is to recover if that trade moves against you. As a general rule of thumb, portfolio losses greater than 25% are very difficult to recover from. 

The lower the risk per trade, more consecutive losses are needed to blow up the account. This may seem like a very negative way of discussing risk management, but even the most experienced traders have had consecutive losses. By incorporating good risk management practices, you can ensure your account stays afloat even after a bad run. The graph below illustrates the exponential relationship between % risk per trade and consecutive losses needed to blow up the account. Keep in mind that portfolio losses greater than 25% are extremely difficult to recover from. Risking 10% per trade only requires 3 wrong trades to drawdown the account by 30%. 

Probability of Consecutive Losses - Playing the Infinite Game

Having a few consecutive losses is part of any trader's journey. What is important is to be able to minimize the losses and ensure they do not create an irrecoverable dent in your trading account. The win rate of a trader depends on what options strategies are used and the probability of consecutive losses a trading account can withstand varies on the win rate of the strategy. Strategies such as debit spreads tend to have a lower win rate but have a higher return when right. Credit spreads on the other hand have a high win rate but lose more when wrong. Neither of these strategies are better than one another, but their varying win rates means that debit spreads have a higher chance of having consecutive losses than credit spreads and the risk per trade must therefore be adjusted accordingly. The table below shows the probability of consecutive losses on strategies with varying win rates. Strategies with a low win rate have a higher chance of accumulating consecutive losses. If your strategy wins 50% of the time and risks 2% per trade, there is a 3.13% chance that 5 consecutive losses will occur which would result in a 10% portfolio loss. Generally, it is best to prepare for having 5-6 consecutive losses at some point while keeping in mind that a 25% portfolio drawdown is very hard to recover.

Summary

The most important thing to remember when trading is that you are playing an infinite game. This means the objective isn't to win every trade, but rather trade in a way that makes you stay in the game. Instead of trying to make money, shift your focus on protecting your account. This makes it much easier to place well thought out trades with better risk/reward ratios. The goal in this infinite game is to protect your portfolio at all costs. This is why it is important to only risk 1%-2% risk per trade as it better equips you for the worst-case scenario when 5-6 trades go wrong. 

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