So, knowing that: (1) you could behave irrationally when it comes to profits and losses; (2) that you may have an entirely different experience with trading once you move from paper trading to real trading; and (3) that it is easy to be swayed from your plan by the crowd—what do you do?
What you do is learn to manage your personal and emotional expectations. Let’s explore this further by looking at two models – one that isn’t helpful to a novice trader, and one that definitely is helpful.
No matter where you were educated, you were likely rewarded for all your studying by good grades. The more study you put in, the higher grades you got. Repeat that process consistently, and you get great overall grades or a high GPA. Schoolwork is a great example of the Accuracy Model, i.e., the more correct answers you have, the higher the grade.
Answer all the questions correctly - get an A. Get 90% of them correct and get a B. If there were 50 questions on the test and you received a 90%, you got 45 correct. You can also say that the ratio between correct and incorrect answers is 9:1 for the entire test. This works well when the point value is the same for each question.
However, in trading, the point value (profits/losses) for each question (trade) can and will vary. This is what drives new traders nuts. If you miss this key point, you can find yourself cramming and reading until your hair comes out.
The model that will help you calculate whether your trading rules are worth following is called Mathematical Expectation. Because it is important to manage your personal and emotional expectations, this formula can do wonders for both your P&L and your emotional constitution that leads to long-term, successful trading.
The gist of the model is that you must keep your losses small and let your winners run. Indeed, many successful traders target a 3:1 or 4:1 relationship between winning trade profits and losing trade losses.
Say you begin testing your trading rules, and you see they win with a frequency of 40%. In other words, you are wrong more than half the time. You also notice that your winners are three times the size of your losers. Should you follow this model or not? How are you going to make money if you're wrong 60% of the time? What will your friends say? Worse, what will your spouse say? All of this chatter is part of your emotional system that can be calmed down by taking a look at the math.
(Frequency of Winning x Average Size of Win) - (Frequency of Losing x Average Size of Loser) = Risk
(.40 x 3) - (.60 x 1) = (1.2 - .6) = .6 Risk Unit
The Mathematical Expectation formula shows that you can have confidence following your trading model because "on average" the rules make money (i.e., the formula’s result is a positive number) even though you lose more frequently than you win.
It's important to note that it's the combination of keeping your losers small and letting your winners run that makes this work. You can’t "wait and see" if your losers will come back to become large winners. That happens between rarely and never. If you're an investor, that might be a different story, but we're keeping this discussion to trading leveraged instruments in commodity futures.
So forget what you learned in school about the rewards that come with being correct and accurate. Be like the superstar baseball player and know that your self-esteem isn’t measured by your batting average. Great trading takes a different type of intelligence that involves accepting loss as part of a winning strategy.