Download PDF on “How to Take a Loss”

Source: Brett N. Steenbarger

Steenbarger’s paper addresses one of the most universally neglected aspects of trading education: while enormous resources are devoted to helping traders find entries, almost nothing is written about how to exit losing positions correctly. His observation is that most traders formulate no clear exit plan when they enter a position, particularly for the scenario where that exit will confirm a loss. The result is the pattern that accounts for more trading account damage than any other single behavior: losses held past their rational exit point.

The central insight of the paper is the distinction between a losing trade and being a loser. At the psychological level, many traders conflate these two entirely different things. A losing trade is a statistical outcome within a positive-expectation system: it occurs on approximately 60-65% of all trades in a systematic trend following approach. Being a loser is a judgment about one’s competence, intelligence, and worth. The equation of the two is the mechanism by which loss aversion takes hold and prevents the correct exit behavior.

The trader who believes that taking a loss confirms something about their inadequacy will find any psychological justification to avoid confirming the loss. They hold the position. They wait for the market to come back to their entry. They reframe the losing trade as a long-term investment. They add to the position to average down and reduce the apparent loss. All of these behaviors are the psychological equivalent of refusing to look at a wound that needs treatment. The wound grows worse. The loss grows larger.

Steenbarger’s prescriptions follow from the correct framing. A loss is information, not indictment. It is the market’s feedback that the entry was wrong at that time, or that the move has not developed as expected, or simply that this specific trade fell in the losing 60% of the distribution. In any of these cases, the correct response is defined: exit at the predefined stop level. The exit is not a statement about the trader’s intelligence. It is the execution of a rule that was designed to protect capital and preserve the account for the next trade.

The reframing that Steenbarger proposes is built around a distinction borrowed from cognitive behavioral therapy: the distinction between a thought and a fact. “I am a loser because this trade is losing” is a thought that feels like a fact under the emotional pressure of a declining position. “This trade is producing a loss” is a fact. “The stop fires when price reaches 2N from entry” is a rule. The rule responds to the fact. The thought is not part of the decision process. Systematic trading rules operationalize this distinction by making the exit automatic when the factual condition is met, regardless of the thought that the emotional state is generating.

The paper is the third in Steenbarger’s series on trading psychology for TurtleTrader. The three vices, finding solutions, and taking losses form a coherent framework: identify the vice patterns, build the process for recognizing and interrupting them, and specifically address the most damaging of the individual behaviors. How to take a loss is the practical application that completes the framework.

Frequently Asked Questions

Why do most traders fail to plan their exits before entering a position?

Because the entry decision is associated with optimism and forward motion, which is psychologically engaging, while the exit for a loss is associated with failure and reversal, which is psychologically aversive. Planning the exit before entry requires engaging with the scenario of being wrong before the trade is placed. Most traders avoid this by focusing entirely on the entry and deferring the exit decision to the moment when the position is losing and the emotional pressure to hold is highest. This guarantees that the exit decision will be made under the worst possible psychological conditions.

What is the psychological mechanism that causes traders to hold losing positions?

The equation of a losing trade with being a loser. When taking the loss feels like confirming inadequacy rather than executing a risk management rule, the psychological cost of exiting exceeds the financial cost of holding. The trader holds to avoid the psychological confirmation, while the financial loss compounds. Steenbarger’s paper addresses this directly by providing the cognitive framework for separating trade outcomes from self-evaluation, which is the prerequisite for executing exits correctly.

How does systematic trend following handle the psychology of taking losses?

By encoding the exit decision in a rule before the position is entered. The stop loss is defined at entry. When price reaches the stop level, the rule fires. The trader’s emotional state at that moment, whatever it is, does not affect the execution. The rule executes the exit that the trader, when the mind was clear and the position was not yet established, identified as the correct response to this price level. The loss is taken not because the trader has overcome the psychological resistance in that moment but because the rule removes the decision from that moment entirely.

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