Humungous Myth #1: You can't go broke taking a profit!

I was on an E-Mini day trading chat forum just now and happened to read a post from someone saying “ I have a sign over my monitors that says ‘You will never go broke taking a profit’”.

I’m sorry but that is utter horseshit. It's not only very easy to go broke taking a profit but it's one of the commoner ways people do go broke. In fact I’ve done it, several times - as have most traders that have been around the block. When I began trading I used to believe this nonsense too but came to realize that this commonly-held belief is actually an amateur’s rationalization of the flawed strategy of exiting one’s winners too soon.

The correct statement should read “You will never go broke taking a profit that is on average larger than your average loss”. In my experience all seasoned traders who have clawed their way to profitability have had to navigate their way through this trap. What’s the trap? It’s that if the profit you take isn't big enough it's quite easy to go broke taking it.

The trap consists of these 2 elements:
1) every trade has a risk of some amount or other, and
2) some trades will incur losses. (Although theoretically one could have a 100% win rate, it’s so unlikely as to be impracticable to consider it)
In theory the smallest possible stop loss is 1 tick but in actuality the minimum stop loss is almost always 2 ticks because entry on the E-Minis is almost always at the bid or the offer. So if you are going to have at least some losers, that means you will have to offset your losses with gains from your winners. So here’s how it becomes a trap: If you consistently exit with a profit that is smaller than your average loss you become a net loser and you will ultimately go broke!

This particular trap was for me by far the hardest one to beat! Like many E-Mini traders, my stop was the low or high of the preceding bar. I actually thought this was pretty good even though this generally meant a risk for each trade of about 5 or 6 ticks average stop loss. So I would enter the trade and sure enough price would generally move at least a point in my favor. I would take my point profit and feel delighted. But you can see the flaw, can’t you? My average loss was 6 ticks plus commission so about 6.5 ticks total. My average profit was about 4 ticks less commission so about 3.5 ticks. Yes, my win rate was higher than my loss rate but not enough to overcome the disparity between win and loss amounts. It was 1 step forward and 2 steps back!

And of course what makes things worse is that when one has just spent the whole morning and had say 4 winners and 2 losers, it is utterly demoralizing to realize that you’ve made perhaps $50 for 4 hours work. Heck, you think, I might as well be working at McDonalds for that kind of money. And even with consistent winners, while you could maybe say you’re not going broke, you’re probably not getting rich either.

So now we should actually amend the saying above to ”You will never go broke taking a profit that is on average larger than your average loss, and nor will you get rich either, until you make the win-loss ratio about 3:1” That’s the ratio of win amount to loss amount that is generally quoted as guaranteeing riches.

So now this introduces the next interesting piece of the puzzle. If you need your winners to be on average 3 times bigger than your average loss, and you know your average loss is going to about 6 ticks, then you see what this means?

It means two things: You need your average win to be 18 ticks, which means that… you need trades that are capable of generating 18 ticks. Wow! That’s a bit different from where we started, taking our 4 tick profit! But remember we’re talking about getting rich here, not just getting by.

OK, so now we’re getting closer! If we need trades that are capable of generating 18 ticks that means two things:
1) We have to use higher timeframe charts because the swings are larger, and
2) We have to hold our trades longer on the lower timeframes when we are in trending conditions.

...to be continued....(BY THE WAY, FEEL FREE TO ADD YOUR COMMENTS