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Cut Your Losses And Let Your Profits Run

When I was recently working to prepare the new EA Analysis pages at MellyForex, something obvious struck me and I thought it would be a good idea to write a short article to explain my thoughts. I then wrote an EA review article the other day which reminded me of that earlier promise to myself so, without wishing to procrastinate any longer, here goes.

As part of the Advanced Statistics of each EA in test, there is a tab called 'Duration' that readers can click on. Clicking this tab displays a scatter graph comparing the profit or loss in pips of each trade taken by the system against the duration of each trade.

As I was browsing through the different pages for each EA, checking the data and charts for accuracy as part of the testing process, I noticed one EA which had taken quite a lot of trades whose trade duration scatter graph looked like this:

This graph shows that the EA holds on to its losing trades for a longer period of time than it holds its winners

What struck me the most about this graph was that it was a classic example which displayed everything that I didn't want to see, despite the fact that the EA in question has demonstrated both reasonable profitability and safety during its time in the MellyForex forward test.

So what's wrong with that graph?

Well, the first thing I should make clear is that I'm not targetting any specific EA in my example above. I've chosen the chart I did simply because this particular EA has made sufficient trades in its forward test for its results to be considered meaningful. There's no reason other than that.

Now hands up in class if you've ever heard the following saying ...

Cut your losses and let your profits run

I'm sure that most traders have heard the above quote, and I'm equally sure that most people know and understand what it means. In case you don't, the concept is simply that a trader should exit a trade as soon as it starts to go wrong. If he doesn't do this, and chooses instead to hold on to the trade in the hope that the market will turn, then there is every probability that the situation will worsen, and the loss will get even bigger still before he finally gets round to pulling the plug.

Before any wise soul tells me that my above statement is nothing more than plain old-fashioned common sense, let me also say that an awful lot of traders act like rabbits staring at a car's headlights when faced with a losing scenario, and a great number will hang on to their losing trades far longer than they should in the blind hope that things will change.

But there is also a double meaning to the quote, which I'll attempt to explain by asking if anybody has heard of another old saying ...

Nobody ever went skint by banking a profit

The above saying suggests that it's worth banking a profit regardless of how little the amount is. Hey, a profit's a profit, and if you keep banking 3 or 4 pips at a time, those pips soon mount up. Until, of course, you hang onto one of those losers longer than you should and end up taking an unnecessary 100 pip hit which wipes out the gains of the last 25 or 30 profitable trades. And how many times have you banked a measly profit, only to watch the market then soar over the next half hour and put on 200 pips or more, leaving you feeling pig-sick that you'd banked prematurely? So, whilst you might not go skint from banking a small profit, wouldn't it be better to resist temptation and at least give those barely profitable trades a bit longer to see if they can turn into something worthwhile?

It's OK, we've all been there, seen it, done it and most of us have even got a T-shirt to prove it. The ability to successfully run profits is a skill which requires great discipline, and it's not really surprising when natural human emotion sometimes gets in the way of a trader's decision making.

Going back now to the scatter graph example showing the EA's trade duration, all of the little green profitable dots are clearly visible on the left of the graph, whilst all of the red dots which show the losing trades are on the right of the chart. The graph is clearly telling us that the longer this particular EA holds on to it's trades, the larger its losses tend to be. It certainly isn't following the old proverb about cutting losses and running profits. Or, put another way, this particular EA is a robot which portrays human emotions.

As I said previously, this observation is generalised and isn't targetting any single EA specifically, as there are a lot of EAs which exhibit similar tendencies. Also, my example shows a profit/loss range of between -60 and +20 pips with durations of typically less than 12 hours, but it wouldn't matter if I was talking about scalpers or long term trend followers where trades last days on end, as it's the general concept of running profits and cutting losses that I'm trying to put across here.

In an ideal world, my scatter graph would have a look and feel something like the attempt I've concocted below using PhotoShop. I've had to use PhotoShop to prepare the image, because I haven't yet seen an EA produce a chart looking like how I would like it to look. Hey ho, maybe one day.

This graph shows how an ideal system would cut its losses and run its profitable trades

So, if any EA developers are reading this article, one thing that they might like to consider is the impact of closing out of any losing trade after a certain period of time. In my initial example above, would overall performance improve and would the losses be less if the EA closed everything regardless after, say, 4 hours? I don't know the answer to that question, but I certainly think it's something worthy of investigation.

In the meantime, seeing as we've now got robots that can mimic humans, I'd just like to say that I've got some dishes that need washing and pile of clothes that need ironing.

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