Legendary Warren Buffet once said, “If you cannot control your emotions, you cannot control your money.” Controlling emotional responses is what will differentiate successful traders from losing ones. In this article, we will analyze the psychological components that drive the market and how to control them to boost your trading account.
Greed might be good, but Emotions are bad
The rationality of financial markets has been one of the most discussed issues in financial economics. Recent critics of the Efficient Markets Hypothesis argue that investors are generally irrational. They often exhibit several predictable and financially detrimental biases, usually attributed to psychological factors such as fear, greed, and other emotional responses to price fluctuations.
A couple of years ago, MIT researchers conducted a trading psychology experiment on 80 trading students enrolled in Linda Bradford Raschke’s trading curriculum. The study analyzed in parallel the trading performance and the emotional state of day traders. A clear correlation between emotions and trading performance was discovered. Specifically, the results showed that subjects whose emotional reactions to monetary gains and losses were more intense exhibited significantly worse trading performance.
Having the best trading plan and following a robust trading strategy made of clear rules is not enough to boost your trading account and stop losing money. What is critical is to stick to this plan and to control your emotions. Trading involves higher brain functions such as logical reasoning, numerical computation, and risk-reward planning. Neurosciences tell us that emotional responses mediated by the limbic system will short-circuit more complex decision-making and will lead to poor decisions and ultimately bad trading.
Trading and the four horsemen
In trading, the “four horsemen” have a name: Fear, Greed, Hope, and Regret. No trader is immune to the trading consequences of these emotions. Even the best investors can get carried away, or else be made miserable by a deep market downturn.
- Fear is considered as the most powerful of all the emotions experienced while trading. When traders are afraid, they will sell a position without logic reasoning. Fear will lead to panic and poor decision making. Fear is a useful emotion if it gets you out of a bad trade. However, fear and anxiety will make the trader freezes and not act when he should have.
- Hope may be the most dangerous of all human emotions when trading. Hope is what keeps a trader in a losing trade after it has hit the stop losses. Greed and hope are what often prevent a trader from taking profits on a winning trade.
|CONSEQUENCES OF FEAR AND HOPE|
|BEFORE PLACING THE TRADE||AFTER PLACING THE TRADE|
|EMOTIONAL CHALLENGES LINKED TO FEAR AND HOPE||Fear of missing out (FOMO)
You place a trade without carefully analyzing the market by fear of missing out a profit
|Price is moving against you, but you keep your position open hoping for a market turnaround|
|Fear of Loss (FOL). You freeze and do not take a potentially winning trade by fear of a loss||Price is moving in your favor. You fear that the profit might turn into a loss and close the trade too early.|
Fear and Hope will impair your trading results both before and after placing the trade. The only way to consistently control your fears and hopes is to bypass your brain and mechanically stick to a carefully back tested trading plan.
- Greed is classically defined as an excessive desire for money and wealth. In the trading world, it is the desire for a trade to provide an immediate and unrealistic amount of profit.
- Regret and the feeling of disappointment associated with it. Regret will instill doubt in your mind and blur your judgment. What happened in the past is not set to reoccur in the future and traders should always analyze the market with a fresh pair of eyes without considering the burden of the past trades.
The market as an emotional rollercoaster
The market is an emotional rollercoaster. In the last couple of years, Sentiment analysis indicators have gained massive popularity. The CBOE Volatility Index (VIX) is now routinely used to time market entries and exits. Behavioral Finance that studies the influence of psychology on the behavior of investors is now widely considered and focuses on the fact that traders are not always acting rationally.
Nobel prize winners’ Kahneman and Tversky identified common cognitive biases that cause people to use faulty reasoning to make irrational decisions at Wall Street.
The five most common behavioral dangers are:
- Overconfidence –Investors over-rate their ability to pick winning trades.
- Loss aversion – research indicates a loss causes about twice as much pain as a gain causes pleasure.
- Chasing past performance –Individual investors who abandon a well-diversified portfolio for bonds, or even cash in the hope of reproducing the same results with new trades.
- Timing the market – Predicting the market movements is difficult, and trying to time the market always involves huge uncertainties and risks.
- Failure to rebalance – the risk/return characteristics of an investor’s portfolio should be independent of what’s happening in the market, and this means selling high and buying low.
Human emotion drives financial markets as much or more than market fundamentals. When things are going as expected, we feel that it will continue and that nothing can stop us. Moreover, when things go wrong, we look to take drastic action. Emotions should always be controlled to maintain awareness. This awareness will protect traders from the negative consequences of impulsive and irrational actions.
Get rid of your emotions with Automated trading systems
It is critical to be able to control your feelings, to develop a trading plan, and to stick to it to become a successful trader. Automated trading systems such as TRADOTO dramatically help traders establishing specific rules for both trade entries and exits. No more guessing. Once programmed, the system will automatically and without any emotion execute the trades. When adequately back tested and optimized, automatic trading systems are the best way to drive your way to trading successes and financial independence. Automated trading systems are the ultimate way not to be influenced by emotions and to let your careful back tested strategies handle the trades logically and efficiently.
To know more
COGNITIVE NEUROSCIENTIFIC FOUNDATIONS OF ECONOMIC BEHAVIOR Fear and Greed in Financial Markets: A Clinical Study of Day-Traders By ANDREW W. LO, DMITRY V. REPIN, AND BRETT N. STEENBARGER* VOL. 95 NO. 2 COGNITIVE NEUROSCIENTIFIC FOUNDATIONS OF BEHAVIOR 353 (2005)
Kahneman, D. and Tversky, A. (1979) “Prospect Theory: An Analysis of Decision under Risk”