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Opportunity Cost in Trading

Sep 2, 2007
All traders have gone through a period they wished they never placed the trades. It could be impulsive and emotional factor that drove the trader to commit these trades. These are trades that he wished he can forget forever and hope to never repeat them sagain.

What is opportunity cost in trading?

Opportunity costs happen when we lose unnecessarily while we pass up the higher probability trades with higher reward-to-risk ratio. Everything in life has opportunity costs and in trading, it's no different. This happens more often to new traders who do not understand this concept, usually causing them to blow out their accounts that shorten their trading career or hobby (however the trader views it).

When traders first start out, they usually begin trading without realizing the consequences of how they select their trades. These unnecessary trades would eventually would affect the future opportunities to profit and better their batting average. These trades tend to be losing trades but without calculating the probability of the success of the trade. When they lose, the equity has less of a chance of getting a better trade in the future. This is opportunity cost. For example, the trade takes a bad trade, loses $300 on the trade. Little by little $300 becomes $500, and then more. Finally when the market condition has turned in favor of the trader's strategy, he no longer has the capital to take advantage of the opportunity.

The other opportunity cost that many don't realize is a psychological cost. When a trader takes a bad trade, loses money, regrets for making a bad decision, causing him to be confused and losing his confidence. This loss of self confidence will affect the next trade which could be a high-probability trade. Due to the trader in a state where he's scared of losing again, he may hesitate on the next trade that could be the next winner. He will realize it only after a long while the cause and effect and the vicious circle this opportunity cost creates.

How does solve this problem? The first thing is to re-evaluate the trading records and sort out the trades that were part of the trading plan and trades that were not (impulsive, on the fly trades). If they are more than a few at least 10% of the total trades made, then a solution must be found to eliminate these impulsive or unplanned trades. Better yet, add the total amounts from these impulsive trades to get a reality check on the costliness of these trades. 10% or more is excessive. Most successive traders would not even permit 1% of the trades based on unplanned setups. Understand that these impulsive trades tend to lead more unplanned trades, such as overtrading. This causes mental exhaustion and leads to losing streaks.

One way to eliminate these trades is to write down and memorize the setups that are part of the plan. Better yet, start with one setup/strategy only and trade it repeatedly until it becomes a routine setup the trader takes day in day out. This way, the trader knows exactly what to do when the setup comes up. Once it's proven that he can trade it with discipline and timeliness without giving in and take impulsive trade then he can add another setup. This is the start of the road to recovery from losing opportunity costs.

As for the losing trades that are part of the trading plan, almost nothing can be done to them. Accept them and move on. Losses and losing trades are part of trading. No successful trader ever trade without losses, far from the truth. Very few successful traders manage to have a percentage of wins to losses higher than 60-70%. Normally it's much less, around 50%. So they must accept the fact that at least 30% or more trades will be turn into losses.

If a trader cannot handle losses, he can either quit trading or alternative find a new or different strategy where he can find an extremely high percentage of wins to losses. But keep in mind that this is a Holy Grail, meaning it may not exist. If they do, the trader may have to wait a long time to find such a strategy.

Before taking a trade, make sure to ask if the next trade will hinder and pay for an opportunity in the future. That is, if the trade meets all the right condition and rules of the strategy and not another intuitive gut feeling trade that will add another check on the loss column. Giving up this type of trades will open up more opportunities for profitable trades in the future.
About the Author
Larry Swing
CEO & Head Swing Trader
swing trading with mrswing.com
+1 (281) 968-2718
Yahoo & Skype ID: larry_swing
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