Opportunity Cost in Trading

Opportunity Cost in Trading
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.

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Larry Swing is the President of the popular day and swing
trading site http://www.mrswing.com a place where you can
find free daily articles and videos covering education,
market analysis and picks from Larry and other well known
traders in the industry.