Know When to Hold Them and When to Fold Them

by Larry Pesavento

Traders like Larry Pesavento admit it is a given that traders cannot win 100 percent of the time, because with reward comes risk, and losses are as much a fact of life as taxes and death. But there are highly valuable lessons to be learned about the trading process that go far beyond the dollar signs. How traders put reliable steps in place to ensure that their performance may be enhanced on the road to success is critical. And, for traders like Pesavento, success is dependent not only on what is done correctly but, also, on what potentially havoc-wreaking mistakes can be avoided.

The three practical principals that can aid traders like Larry Pesavento in anticipating and possibly avoiding mistakes are probability, self-discipline and responsibility – simple enough to write, but harder to carry out.

Successful traders such as Graham, Buffett and Pesavento would never deny that mental preparation is just as necessary as charts and market signals. Trading is all about probabilities and every trader, whether a novice or an expert like Larry Pesavento, encounters a losing streak or draw-down of equity. Success as a trader is measured by how well losses are handled mentally.

Pesavento points out that a "sure" sign of potential disaster is holding large losses in open positions while at the same time taking many small profits. This is contrary to the market adage by a wise trader/mentor from Commodity Corporation, Amos Barr Hostetter, who said, "Take care of your losses and your profits will take care of themselves." Experts like Larry Pesavento know a trader who mentally dupes himself into believing that the small profits will offset the large losses is taking a dangerous ostrich approach.

Most losing streaks are the result of probability distribution. According to skilled traders like Larry Pesavento, if over the course of 100 trades a system encounters a losing streak of up to eight trades in a row, this is the time when the trader begins to question the validity of the system. It also normally is the worst time to stop trading as long as the trader has followed his methodology, because it’s been shown by experts like Pesavento that winning streaks generally follow losing streaks.

Examining daily trading logs enables a trader like Larry Pesavento to spot some common trading mistakes such as lack of discipline, sloppiness in trade preparation, impulse trading, impatience, and all of the other cousins and uncles in the "mistake family." One of the big advantages of the pattern recognition method of swing trading is the probability associated with each pattern. As pointed out by Pesavento and other successful traders, winning is a matter of executing all of the trades as the patterns develop.

Larry Pesavento and other profitable traders know that they must train themselves to think in terms of probability for three very important reasons:

  1. No one knows with 100-percent certainty whether the trade will be profitable or not.
  2. No one knows how much money will be made or lost on a trade.
  3. If the trader does not control the profit outcome and does not know with 100-percent certainty which trades will work, then the trader should spend 100 percent of his time concentrating on the only element of the trade he can control – the risk of the trade.

Top traders like Larry Pesavento note that the key to success is the ability to pinpoint how much one can afford to lose. Winners think "how much can I lose?" Losers think "how much can I win?" This fact is easy to demonstrate. Anyone visiting Las Vegas – has been greeted by brightly colored, flashing slot machines that beckon the full-pocketed tourist with the promise "Win One Million Dollars!" However, no visitor has ever seen a sign that reads, "This machine has taken in three million dollars this year." When a trader like Larry Pesavento begins to think like the "house" the probability of winning is increased.

It has been pointed out by traders like Larry Pesavento and others that thinking about losing requires discipline. By focusing acutely on a trading plan, the probabilities for profits or losses and streaks of each, and risk control, risk-taking becomes more manageable and can give traders the ultimate gift – freedom. In fact, making discipline a daily habit allows traders like Larry Pesavento "to weave a habit of a strand a day of discipline until the cable of discipline is almost unbelievable."

Pesavento and others in the market know that discipline in trading presents itself in several parts. First, there is preparation. Trading is simple, but it takes time. Many hours of preparation occur long before any trade is entered.

These steps include:

Mental – Traders like Larry Pesavento know they must think through what risks are present in the trade, and know in advance how to get out of the trade and at what point. Mental preparation, from my experience, also assumes eliminating alcohol consumption from Sunday through Thursday of the trading week, because it typically takes up to 24 hours to completely leave the blood system. It’s best to have the brain working at an optimal level.

Technical – Methodologies vary by the individual trader. According to Pesavento, all trading opportunities should be explored. A daily ritual of scanning charts will present many good opportunities. This is the time consuming part of trading. Opportunities, however, do not guarantee profits.

Physical - Traders need to release tension in a positive way. Take time to do some type of exercise like golf, tennis or walking.

Traders like Larry Pesavento are quick to point out that discipline is also necessary on the execution side of trading. Risk control is the most critical element of the trading process. Never forget how a devastating loss can destroy the "psyche." It damages the trader’s soul.

Traders like Larry Pesavento note that monitoring a profitable trade in progress also requires discipline – follow the trading plan. Do not be concerned about minuscule fluctuations if your goal is higher. There are two questions that every trader should ask: "Has the market changed since I placed the trade? Can I afford to take the risk on this trade?" Pesavento and others will state that if the answer to both of these questions is "yes", the trader should stay in the trade.

Traders like Larry Pesavento know that along with discipline, responsibility plays a significant role in the trading game. Once in the market, the trader alone has responsibility for his or her trading decisions – no one else. Not assuming personal responsibility is like jumping into a fast-moving river without a life jacket in the hopes that there is a lifeguard somewhere on the shore. The trader can keep afloat only if he is responsible for his own destiny. Larry Pesavento says a smart trader will take joy in the good decisions and learn from the bad ones. Place the orders, close the orders and take the profits. Or, swallow hard, and take the loss if that’s the responsible thing to do and your plan points in that direction.

Pesavento notes that traders can and do fall into the habit of making excuses about why something went wrong. Again quoting Hostetter, "Forget your profits, but forget your losses faster."

Taking responsibility can be improved by including a few steps or reminders in the trading plan. Experts like Buffett and Pesavento point out that what works for one trader might not work for another. The way to handle this is to place a written statement on the computer. The statement says: "Has the pattern in the trade changed from the original pattern? Has the initial price objective been reached?" If the answer to both of these questions is "yes", it’s time to exit the trade. If the answer is "no", then the trade must continue. Pesavento opines that trading is a business of dealing with probabilities, not certainties. Hostetter held that, "We never know which trades will work— the problem arises when we only ‘think’ we know."

Probability, discipline and responsibility are traits that every trader should strive to attain. Larry Pesavento states that probability assures that losing streaks will develop just as winning streaks will. What matters is how to recover from those losses. Discipline and responsibility help to prevent devastating losses and aid in recovery. Have the discipline to exit or stay in a trade, and take responsibility for the actions and outcome. Again, losses are not 100 percent preventable; however, with the right trading strategies and mental focus, many may be avoided.

Back To Articles of Interest