One of the biggest mistakes I see newbie traders make is the different way they treat realised and unrealised profit and loss.
14yrs ago when I embarked on a professional career as a trader the treasurer of the bank I worked for drilled into my head the term mark-to-market. That lesson is vitally important if you want to avoid falling for a classic mental accounting bias. Accepting a loss is psychologically painful so we will do all that we can to avoid experiencing the pain, therefore the classic way for our minds to deal with this cognitive dissonance is to simply say I have not closed this trade so I haven’t made any losses yet. The problem is that by doing this we tend to add to the risk of our portfolio by ignoring our financial reality.
You really need to absorb the 2 points below:
- A paper (unrealised) loss is a real loss.
- A paper (unrealised) profit is a real profit.
Lets look at a simple example how ignoring reality can get you into trouble.
Trader X has $10,000 in his trading account. He opens a position on the EUR/USD the current mark-to-market (MTM) P&L of the position is – $3,000 however Mr “X” doesn’t believe that he has lost anything yet as he is planning to ride through the current unfortunate storm. He then places another trade;
“X” shorts the AUD/USD and is quickly into the money with $1,000 MTM profit, but the EUR/USD trade keeps hurting and now both trades are under water to the combined total of -$7,500 the brokers are calling for margin top-ups and X realises one more small move against him and the account will be worth zero. He now closes all his losses and accepts the fate of a much larger loss than X had ever envisaged taking.
If you want to succeed in trading you have to start marking to market, and never stop doing it!
NB: I think an important trick is to only show the PNL column not like the image below with realised and unrealised shown separately.