Why Most Traders Go Broke: It’s Not Your System, It’s Your Strategy

Profits, Pitfalls, and the Psychology of Staying Solvent

[Originally published in 2011]

It's important to understand the limitations of the strategy you're using.

Having a system to anticipate market direction is only one piece of the puzzle. In addition to a system that helps guide you on direction, there are two key strategies every new trader must develop:

1) A method of risk management, and
2) an exit strategy.

When do you close a profitable trade? Do you take partial profits or full profits? When do you cut your losses and bail on a losing trade? I have said this many times, but when it comes to stop-losses, you should know your exit before you enter the trade.

Once you've entered the trade, your emotions take control and will compound any and all of your mistakes.

Think of it like a poker table. If you've got $2000 in "profit," but you're still at the tables, it's not real profit until you cash out your chips. As long as you’re still placing bets, the potential exists of giving it all back and more.

There's an old trader adage: "You'll never go broke taking profits." I would add my own adage to this: "If you never take profits, you'll eventually go broke." Especially in a range-bound market.

A trending market is a different animal, but even then, management of profit and loss is key. Let's drive this point home with a concrete example: Imagine you were a bear heading into 2008, and you made a killing on your shorts during the crash, but you never took profits. By 2011 you'd be back to even… and by now you’d be living on the streets holding a “Will Short for Food” sign and ranting incoherently about Quantitative Easing to random strangers on park benches.

What's your strategy to protect profits?

Trading is always a risk/reward proposition. How much are you risking, and what's the potential reward? Are you holding out to try and gain an extra 2% while risking 10% or more? Does that make any sense?

Is the market approaching an inflection zone (a potential reversal zone)? If it is, your risk is increasing, and it's important to understand that in your decision process on what to do with your profits.

If the market is approaching support in a downtrend, how much are you risking to hold onto your positions, hoping for a break? Can you instead close some positions and get short again if support fails, or short again from higher levels if it holds? The reverse is true in an uptrend.

These are a few of the questions you need to ask yourself to be a successful trader. Being able to anticipate direction is only part of the equation; if you don’t develop a system for managing trades — knowing when to take profits and when to cut losses —then knowing direction won't actually help you much. You'll eventually go broke, as 95% of traders do.

Conversely, a winning strategy can make even a losing system somewhat profitable. If your system is wrong 60% of the time, but you only lose 5% when it's wrong and gain 10% each time it's right, you will make money in the long run. If you have a system that's right 80% of the time but you never take profits or you consistently make bad entries, you will bankrupt yourself through poor management. The system can't save you -- just like in the rest of life.

Ultimately, you have to develop a clear strategy, clear goals, and learn to bite the bullet a lot. Trading is almost always about doing the exact opposite of what your emotions want you to do. You have to short when the rally looks like it's going to the moon; and you have to buy when there's blood in the streets.

And many times, you just have to stand aside and wait. This one is especially tough for Western society: the idea that non-action could be “productive” is difficult for our culture to swallow.

Complicating the matter is the fact that, as a trader, you often have to act on uncertainty; and you also have to not act on uncertainty... and somewhere along the way, you have to learn the difference between which type of uncertainty is which.

A lot of that goes back to the risk/reward equation and understanding probabilities. If you chase a Royal Flush on every hand you play, you'll go broke long before you hit your cards.

The good news about patience is that the market's not going anywhere -- there are always trades to be made tomorrow.

In other words: There’s always another hand. Don’t blow your stack chasing this one.