Some silly ways of looking at P/L

This post attempts to provide some open-ended insight into the way in which different mindsets toward P/L could potentially impact on a trader’s decision making. My comments are intended to be general in nature, and not specifically related to any particular trading strategy. IMO it's helpful to examine the reasons for why we think the way that we do, if it can help us to improve our trading psychology.

Let’s suppose I’m +30 pips in a buy trade and (for better or worse) I move my SL up to breakeven.


(#1) Conventional thinking tells me: “Hooray! I can relax, I’m in a free trade. I can’t lose now”.


(#2) Just for the sake of argument, here’s a different way of looking at it. I can still potentially lose the 30 pips that I’ve just made. Hence those 30 pips aren’t really ‘safe’ until I bank them.

To further demonstrate this, suppose (hypothetically) I was to close the trade, and open a new one of identical size, and likewise with a SL 30 pips away. Apart from the additional br0ker cost, my total equity, my exposure to risk, and my consumed margin, all remain completely unchanged. But despite this mathematical reality, if I get stopped out, I’ll have a trade that will show as a l-o-s-s in my books, and I can feel the blood pressure starting to rise again!

But hold the phone — that’s not necessarily true if I mentally group this trade with the last one. I can ‘afford’ to lose 30 pips, because I just won 30 pips..... which of course brings us back to the original ‘free trade’ mindset (#1). Things are apparently not so bad after all!

But if I’m allowed to mentally (and arbitrarily) group trades together, why can’t I ‘afford’ to lose 30 pips because I made a 30 pip winning trade several weeks ago? Or why can’t I afford lose 200 pips because I made 200 pips back in April, or lose 1,500 pips because I’m currently 1,500 pips up for the year? What makes the most recent trade seem like the most important one, when (everything else being equal) the pips (or dollars) won/lost on one trade are no more or less significant than the pips (or dollars) won/lost on any other trade? Answer: the illusion of “recency bias” (which also provides the motivation for rescue/recovery trading). Recency bias is a symptom of mindset #1.

So, to summarize, here is the fundamental difference between the two mindsets:

Mindset #1 is the 'textbook' thinking that most traders seem to adopt. It takes the view that the 30 pips are not at risk, because the SL is at BE and we're in a free trade. I've gained 30 pips, hence I can ‘afford’ to lose them.

Mindset #2 takes this opposite view: those hard-earned 30 pips are every bit as valuable as any other 30 pips, and are at risk unless/until I bank them by closing the trade. If I lose those 30 pips, my eventual bottom line will be 30 pips worse off than it otherwise would have been.


(#3) Now, just to confuse things even further, here’s a third way of looking at the same reality: I’m currently +30 with the SL at BE.

Suppose I choose to take the view that, at any current point, I have an approx 50/50 probability that price will rise or fall henceforth. In other words, my 30 pip profit will continue to increase (hence keeping the position open is a good decision) around 50% of the time, and it will decrease (hence closing the position would be a good decision) around 50% of the time. Over a large number of trades, then, this will tend to be self-balancing, and hence it really doesn’t matter, mathematically, whether I close the trade or not. If I take this view, then, my 30 pips is effectively as good as banked, and closing the trade becomes little more than a comfort measure.

Now, to summarize, here is the fundamental difference between mindsets #2 and #3:

Mindset #2 takes the view that (floating) losses are inconsequential until the trade is closed and the profit (or loss) is realized. While unrealized, the 30 pips are at risk; when the trade is closed, the 30 pips are safely banked.

Mindset #3 sees no difference between floating and realized losses. Again, if I use the example of closing and then re-opening an identical position, I’ve realized my P/L, but (apart from the broker costs) my total equity, my exposure to risk, and my consumed margin, all remain completely unchanged. If we choose to adopt this view, all profits and losses are tangible irrespective of whether they've been realized or not.


(#4) There are probably other potential mindsets that I haven’t thought of.


I don’t think it’s possible to categorically prove that one mindset is any more valid than the others. (Just as it’s impossible to prove whether it’s better to think of P/L in terms of pips, dollars, or percent equity — all have their pros and cons — a worthy topic for another post?). One mindset may be psychologically more palatable, or otherwise possibly more healthy, than the others, but it ultimately comes down to personal preference.

However, in exercising my own preference, I definitely favor mindset #3. If we extrapolate the ideas in #3, they can lead us to the realization that what has happened in the past — closed trades, or even everything that’s happened to date in currently open trades — can’t be changed, and is therefore irrelevant to any subsequent decision-making. The market takes no cognizance of my P/L, so whether I’m currently +30 or –30 is immaterial — any decisions should logically be based on whether price is likely rise or fall henceforth — and if I have no objective statistical reasons to substantiate a decision, then whether I close or not really makes no difference.

Moreover, #3 makes initial risk/reward calculations seem meaningless, because risk and reward are always changing dynamically as the trade unfolds.

As I’ve attempted to argue in all of the same-pair-hedging/martingale/MM threads, success is ultimately about being net long while price is rising, and net short while it’s falling, heavily/frequently enough to overcome costs. The more accurately the trader adjusts his net position relative to turns in the market, the more pips he’ll bank. Everything else is ultimately smoke and mirrors, a figment of the trader’s P/L-fixated imagination. These conclusions are possible if we choose to adopt mindset #3.


Some other considerations imposed by the different mindsets:
Mindset #1 can justify the pyramiding of orders: if I’ve safely locked in profit on a trade, I can afford to risk that profit by opening another trade, pyramiding (averaging up) into what is hopefully an emerging trend. Whereas mindsets #2 and #3 both tell me that (everything else being equal) all orders contribute equally to bottom line, and if the subsequent positions lack objective statistical backing — or worse, are a statistically losing proposition in their own right — then overall, I’d be better off without them, regardless of whether they’re being ‘funded’ by prior wins or not.


A final summary, just in case the above was unclear:

Mindset #1: the trader is predominantly focused on the performance of individual trades, and his approach is motivated by things like initial risk/reward, and possibly even rescue/recovery through the arbitrary mental grouping of his most recent trades. Pips (or dollars) gained in current or recent trades are seen as being expendable and can be used as ‘risk capital’ in new trades. (I don't want to get into the same-pair hedging argument, but those who see same-pair hedging as a strategy in itself would likely fall into this group, also).

Mindset #2 represents a different ‘level’: the trader is freed somewhat from viewing each trade as an individual entity, and becomes more focused on on pips (or dollars) gained overall. He sees each pip (or dollar), recent or historical, as being equally valuable. In his view, pips are not safe until trades are closed, hence he seeks to realize gains as early as he sees as being sensible.

Mindset #3: the trader is no longer focused on P/L: whether P/L is floating or realized is irrelevant. All that matters to him is whether price is henceforth more likely to rise or fall, and whether he is correctly aligned (long or short) to exploit this. (Of course how successfully he achieves this depends on his knowledge/skill in determining probable directional or behavioral bias). Trading becomes a dynamic, fluid process, and all decisions are based solely on market behavior and current probabilities.

Of course it's possible that a trader's view includes some aspects of one mindset, and some of another.


Finally, here’s another conundrum to ponder: the textbooks tell us that it’s better to stay out of the market, if we’re uncertain, than to risk making a loss.

Well, if I make a 30 pip loss, my eventual bottom line will be 30 pips worse off than it otherwise would have been.
But if I miss out on a 30 pip win, my eventual bottom line will likewise be 30 pips worse off than it otherwise would have been.

Again, it’s just another way of looking at it. And perhaps just a silly one, in keeping with the thread title.

All these dilemmas create stress, the very "thing" that steals the joy of our lives.

We can get rid of all that if we create a strategy with a fixed SL and TP for every trade. That way the only question is WHERE. This also allows us to close trading terminal after the WHERE is set which creates even less stress.

The strategy has to have a definition of a trend so buy/sell is not a question and risk per trade should be also set.

So that way all we seek is WHERE and if we can't find it we don't trade - even less stress.

Edit: my way of thinking about the profits is they are not banked untill they are atually withdrawn.

I completely agree with mindset #3. I sense a smart man's way of saying something very important by appearing to say something 'silly' in the that titling. hehehe.

"...success is ultimately about being net long while price is rising, and net short while it’s falling, heavily/frequently enough to overcome costs."

This alone is a gem. I'm seeing the wisdom now in trading baskets that currently reflect money flow realities in the market. The next challenge for me is continually adjusting exposure and net positions to align with this flow without necessarily staying out of the game at any point in time.

Hi David

Absolutely brilliant.

Over the years I have loved your wonderful indicators, your clear wisdom and your thought-provoking posts.

Thanks for another gem,

Best regards,

Old Dog

.

The best way to do it I have found is to open simultaneous orders upon entry that represent your risk based on what your sl is. whether you using a fixed amount of money or a % base risk model. So say you are entering on a pullback you would open up 3 orders all together combined with the sl being hit, 2% of your account.

From here you can do many things that represent similar explanations that hanover says however my purpose of this post is to add also what I think is a helpful way to look at exiting trades.
Say have your 30 pips on the table, the problem I find a lot of the time with BE depending what style your trade is market will retrace very often against you and take you out very easily. Unless of course you caught a nice breakout. So with 3 positions you can take your 30 pips off with 1/3 of the 3 orders that represent a position, so you bank some, then then move your stoploss up so it is not at breakeven, but a distance below so that if you were to get stopped out, it would be the equivalent of the profit made. It is usually just below entry, depending of course all where your first target is, and such then your second position can be taken for profit at next level or depending how exit ie S/R , and with final 3rd position as a runner or trail the stop to earn extra profit.

All other methods are fine and work depending on who you are as trader but I am simply trying to offer another method to compliment this. Because like forex the market moves very much in waves and thus I think it is important to be very "flexible" with where you exit as this really is your bottom line.

Hanover, all of us multilevel/hedgers are usually net long or short. Did you know that?

Further, the reason we hold trades that are negative is that at some point they will come back. The whole similarity concept that FF has recently purged itself of has produced some results to this effect. If you believe that is rubbish, then go back to the anecdotes that the market ranges 70 -80% of the time.

Lastly, trades are never held forever. All multilevel/hedgers keep an eye on DD, if that exceeds a certain mental level, trades start getting closed at a loss.

Just putting that out there.

I agree with you here. And the first lesson a trader must learn is that: "No one" can predict the future.

Firstly. It makes the big difference whether you close your trade or not. It's the difference between a pro and an amateur.

As a scalper, 30 pips means a lot to me. What does 30 pips means to me? Example: I will divide 30 pips into 3 trades (including spread) with a 10 pip stop loss. Those are 3 opportunities. Given a 50/50 of winning and losing, you actually have increased your chances, you have got 3 extra chance for opportunity. And 3 extra chances of losing without breaking your bank.

More elaboration: Person (A) and (B). (A) moved stop loss to break even and was stopped out. (B) bank profits and now has 3 more chances to win. (B) also has 3 more chances of losing without touching his original bank. Imagine (A) and (B) as farmers. At the end of the season, (A) has no more seed to plant. (B) has 3 more seeds to plant for the next season. Who would you rather be?

Vice versa: with 300 pips profit or 3000 pips profit. 300 can be divided into 3 trades with 100 pip stop loss. 3000 can be divided into 3 trades with 1000 pip stop loss.

Which chances would you choose? 1. Guaranteed profit now or 2. uncertain future; you may or may not get anything. 1. is the 'probability wise' choice. I'm a trader, I'm not a gambler. I will take "guaranteed" over "uncertainty" any day.

Any profit is not a resource that should be squandered. It should be used and recycled for better use. Just because a trader made (big) profits, that doesn't entitle him to risk all that profit for one big swing, for a home run. Closing a trade should not be a "feel good" measure. It should be a mathematical measure.

Exactly. End of story!

Chance upon this which is a typical view that's misguided.

If those 3 statements holds true and unchanged throughout and in most ways they are for many, and upon this premise this whole write-up is based upon, then this sudden change of posture without reason offered is where the distortion takes place -

YOU do not have the proof, that contradicts YOUr 1st statement.

YOUR view of the market with whatever the reason behind it makes it no different than anyone trying to tell the weather.

YOU do not know if the 'price is rising' or '...falling'.

Change YOUr belief system first then seek to change(properly substantiated) the premise that traps YOU and when YOU have successfully inverted negatives to positives then redo this exercise again.....YOU may be surprise how such a write-up will read. (YOU = H......+...+...)

Many thanks everybody for your replies.

All I attempted to present was some open-ended insight into the way in which different mindsets toward P/L, both ‘textbook’ and otherwise, could potentially impact on a trader’s decision making. The underlying concepts were supposed to be independent of any particular trading methodology.

However, I see that folk have replied with their own methodological specifics, and presuppositions about what is possible, and what is not. Fair enough, but I’d rather not get drawn into this kind of debate, as it’s been done to death elsewhere.

Everything in my original post makes sense to me, and I don’t see any obvious contradictions in my logic, although upon re-reading it now I concede that some of my explanations could have been better presented**. Hey, no big deal, for better or worse it was an attempt to think outside the proverbial box, and I’m happy to leave it at that, and move on. I hope that somebody found parts of it thought-provoking.

**[EDIT] I have rewritten parts of post #1, to hopefully make it more clearly understandable.

My preference is to use the account balance as a "line in the sand".

You put it very well : "...success is ultimately about being net long while price is rising, and net short while it’s falling, heavily/frequently enough to overcome costs."

encapsulated as such:

"Keep what you have and get what you can"

Simple is best, but don't ask me. I know nothing.

Hanover - completely unimpressed by the title. Silly has no place in it! ;-) You are spot on with your comments.

I think that for the 'zen' of trading, you need to consider all these perspectives at the same time. They are all variations on a theme, which is how you view risk and potential profit.

I consider past profits of the previous week as potential 'gains to be lost', but I really wouldn't want to dip into them very far. Later in the week, if I've made some profits (closed trades, not open ones), I will mentally use that as my buffer and not want to give back more than 20-50% of those.

For open trades, I've had to learn to ignore the 'profits' showing on the table and mentally only tally where my SL's are placed. For my top/leader trades, that don't have SL's, they are in my potential loss box (even if they are showing a profit), as they market can (and often does) pull back and turn them inside-out.

It's like learning to drive a car on the motorway, where you have a sense of who's next to you, behind you (and how close) and the car(s) in front of you at the same time. New drivers will be focusing mainly on just the car ahead of them, or just the car behind them, or just the one next to them (that veered a little too close) and that's often when issues arise.

Great thread. :-)

...and this is a good description of the length, breadth, width required if YOU do the 1st step - change YOUr belief system -
http://www.forexfactory.com/showthre...20#post2212020

I have been a silent ForexFactory reader for a while, this finally prompted me to post.

I do believe that using a method where you constantly gauge trade continuation probabilities is the best choice. I use machine learning to evaluate the probability of different trade outcomes at every point of a trade. Say I open up a trade, every 15 minute bar I train several machine learning methods using the past 100-300 examples of similar previous price action and I evaluate the probability of positive and negative continuations. If the probability that the trade moves against me becomes large I close a position, if it continues to be favorable I continue to hold this (why would you close something that has a positive expectation?).

Clearly there is a lot to the above, different machine learning methods can agree/disagree, so it's actually more complicated than I make it seem here. However machine learning methods do help you a lot here. For example last Friday I was holding a profitable open short trade and the machine learning analysis accurately predicted that there would be a 3x increase in volatility during the next bar (the NFP release) and that the probability of a significant down turn was large. I therefore closed the position before what would have been a total reversal of my trade. The above would have been obvious to traders without the machine learning, that's why I give it as an example, but the statistical learning methods capture very similar phenomena that might not be so obvious.

I may open up a thread going forward about this topic if people are interested in learning how this is done.

Yes exactly and based on that I'm guessing he's an intelligent, smart, good heart person with low self worth.

Thanks for your positive feedback.

Perhaps I should have put the word "silly" inside speech marks. I was working on the assumption that mindsets #2 and #3 would seem silly to many traders, who have spent their careers steeped in mindset #1.

Would love a thread on this topic.

As a newbie my main problem seems to be knowing when to stay in a trade and when to exit, any help or different way of looking at this would be more than beneficial.

I have already started a thread on machine learning here. We may eventually reach the topic of building models to determine trade continuation probabilities (although it might take a while!).

Personally, I don't like to pigeonhole myself into any one category. I tend to be many things all at once. And I've never considered the mindset nuances you've expounded.

But strangely enough, after reading and re-reading your OP post, I find that I'm 100% Mindset 3, gravitated from Mindset 1 since my rookie days, and finding Mindset 2 completely foreign to me.

Interesting. To me anyway.

Good thread!

Excellent!

I believe that mindset #3 is something like a 'zen' state, where the trader becomes totally focused on the market, rather than basing his decisions on the results of prior trades, or his P/L.

I see it as being a little like blackjack, where the correct play is always to play the cards in front of you, and the relevant probabilities; it has nothing to do with the result of previous hands, or your P/L for the session.

The market takes no cognizance of the trader's P/L, therefore there's no mathematical edge in making P/L-based decisions. Some folk will no doubt argue with that, but I believe it's true, and I also think that being overly P/L-focused is a big reason why so many new traders fail. Seneca_pilot sums it up thus:
I'm trying to work toward mindset #3 myself. Intellectually, the concept is simple enough; existentially, it's not quite so easy.

Cheers & profits,
David