Cut your losses and let your winners ride

This quote is the perfect corollary to Livermore’s. Just as he preached “sitting”, letting your winners ride is the same idea. If you have on a position and it’s working, let it make you money. Don’t cut it prematurely for the sake of booking a small profit. Don’t get scared and exit on the first reaction, when all of your trading rules dictate staying in. If it’s a winner, and it’s working, then let it ride. Winners are good—embrace them.

The important flip side is how to treat losing trades. The first lesson is that losers have to be cut at some point.  Otherwise, a losing trade can keep eating away at your P&L, undoing the profits from any winning positions. If you cut losses at a pre-defined level, then they stop—and presumably your wins can be larger than your losses.

The math behind this is compelling. If you assume that your average winner make 1.6x what your average loser loses, then you only need to be right 40% of the time in order to make money consistently. By keeping the leash short on your losses, then you can let the math of statistical expectation work in your favor. Cut losses and let your winners ride.

There is another aspect to this. A loser isn’t just a trade where you get stopped out at a pre-defined loss limit. Imagine a trade that isn’t making money and has just been languishing on your books—this is also a loser. Cut it, free up financial and mental capital  and move on.

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