Emotional Traps of Trading
One of Warren Buffet's most famous quotes is "Be fearful when others are greedy and greedy when others are fearful." While this is good advice for contrarian investing, it doesn't apply to short-term trading, where emotions like fear and greed can be extremely detrimental. Trading can be a roller coaster of emotional highs and lows - from euphoria to anxiety and panic. But achieving the best results requires trading without letting emotions dictate your decisions. In this article, we’ll talk about some examples of emotional traps, and how to avoid them.
When you’re in a winning trade, you don’t want the thrill of winning to end. It may seem like your profit keeps getting larger and larger. You know you should probably close the trade and lock in your profits, but you don’t do it because you’re worried you might leave money on the table. This is greed. You think the trade will keep going your way, but it reverses, and all your profits disappear. The lesson: don’t try to take more from the market than it is willing to give you. Have a predefined exit plan, and stick to it.
On the other hand, when a trade starts losing, you might feel fear, thinking of the amount of money you could lose. As your trade gets deeper in the red, you want the pain to end. You don’t want the loss to get any worse, so you close the trade, even though your stop loss hasn’t been hit yet. After you close the trade, the price reverses, and you kick yourself as you see the amount of profit you could have made if you had held onto the trade. The lesson: always set a stop loss so you won't be afraid of losing too much money, and let losing trades play out until your stop loss is hit. Don’t let fear convince you to close the trade too early.
While some traders close losing trades early because of fear, others will let loss aversion prevent them from closing the trade at all. Loss aversion means that you will try your best to avoid incurring a loss. When you’re in a losing trade, you don’t want to lock in the loss (the loss is unrealized until you close the trade). Even if you did the right thing by setting a stop loss, you may decide to move it further away so it doesn’t get hit, or you may remove the stop loss altogether so that the loss is never realized. You might change your trade plan to close the trade when you get back to breakeven. But your position just keeps going deeper in the red until you can’t take the pain anymore, and you close the trade at a much bigger loss than it would have originally been. The lesson: trade with a smaller position size so that you are not afraid of taking a loss. In addition, your exit plan should be based on a predefined strategy or key levels in the market. Other traders don’t care about your breakeven price, so it is not a key level in the market. Don’t make decisions based on your breakeven price, or whether you have a profit or loss.
You’ve probably heard of FOMO, or the fear of missing out. This can happen when you see one of the popular stocks going higher and higher, and it seems like it will just go up forever. You don’t want to sit on the sidelines and watch the market action without taking part. You’re missing out on profits. You decide to buy this stock so you don’t miss out, even though you don’t have a strategy giving you an entry signal. You end up buying at the high of the day or the all-time high of the stock. The lesson: don’t overtrade. When you trade because of FOMO instead of because of a strategy, you will make bad trades. They may work out sometimes, but overall, you will not have an edge if you are making trades just to be in the market.
I hear about traders making these kinds of mistakes all the time, and I used to make some of these same mistakes myself. Of course, the best way to avoid letting emotions drive your trading decisions is to use automated strategies. By automating a strategy and removing as much human interference as possible, you can eliminate virtually all of these mistakes caused by emotions. But if automating your strategies isn’t an option, there are a few ways to minimize your emotions and their effect on your decision-making.
In order to avoid these mistakes and trade without emotions, risk management is extremely important. Your position size should depend on where you place your stop loss, and the maximum amount you are willing to lose per trade, which shouldn’t be more than one or two percent of your total account size. Losing is a natural part of trading; even the most profitable traders experience losses sometimes. But if you practice sound risk management, you should be completely fine with taking a loss.
If you’re new to trading, I would highly recommend starting off with simulating trading, so you don’t have to risk real money while you learn. Some traders don’t like simulated trading, because they believe you can’t learn to control your emotions if real money isn’t on the line. However, I think simulated trading is useful for a few reasons: it lets you get comfortable placing orders and using the software, and it lets you practice executing your strategy. Additionally, the skill of trading without emotions while making simulated trades can be transferred to live trading with real money. With simulated trading, you know you can’t lose money, so emotions won’t affect your decision-making. When you subsequently start live trading, you can make a conscious effort to trade the same way. It may be harder than it sounds, but the key is to trade with small enough positions sizes so that you won’t get emotional, whether you’re winning or losing. One trick that helps me is to think of profits and losses as nothing more than numbers on the screen, rather than real dollars. Of course, that doesn’t mean you should trade recklessly. But it should help you to avoid the emotional highs and lows of winning and losing.
Hopefully this article has helped you recognize these emotional traps in your own trading, so you can avoid letting emotions lead to mistakes.