In my most recent webinar the “Trading Mindset” I looked at the role that a trader's psychology plays in their success or failure, and I touched on how we can learn to recognise and combat subconsciously emotional trading, which rarely ends up generating profits for traders and frequently results in compounding their losses.
In a previous article, I looked at several common biases that can dog traders, and interfere with their decision-making and thought process, whether they realise it or not.
However, in that article, I didnt touch on one of the most fundamental traits that traders, and in particular new or novice traders, exhibit, and that is loss aversion
Loss aversion is a common psychological bias that affects many investors and traders.
The name refers to the tendency of traders to avoid losses rather than seek gains. In other words snatching at profits closing winning trades too early, whilst letting losing trades run, in the often forlorn hope that they will move back into profit. Even if they have moved to and through a trader's stop loss level.
Loss aversion often leads to suboptimal decision-making and poor performance in the financial markets.
One of the main effects of loss aversion in trading is that it can cause traders to hold on to losing positions for too long, hoping that they will recover, instead of cutting their losses and moving on.
To overcome loss aversion traders need to be aware of their emotional reactions and cognitive biases, and where possible try to remove them from the trading process.
Thats easier said than done of course. After all, these biases and heuristics, or decision-making shortcuts, have become hardwired into our brains through thousands of years of evolution.
However, the decision-making tools we used to good effect as hunter-gatherers, such as fight or flight, are not suited to modern-day life and certainly not to trading.
To try and overcome these shortcomings we need to think rationally and trade in a disciplined way.
One way of doing that is to use a trading plan which defines items such as which markets you will trade, the type of trading you will undertake and the trading opportunities you will look for.
Your trading plan should also determine your minimum risk-to-reward ratios, the size of each trade you undertake, the number of trades you have open at any one time and the percentage of your account that you are prepared to commit to an individual trade, and your trades in aggregate.
The trading plan should also say something about how much of your capital you will commit to trading and your attitude to factors such as overnight risk and the use of stop losses.
A disciplined approach to money and risk management is a least as important to success as spotting potentially lucrative trading opportunities.
Alongside our trading plan, which we can refine by making the most of our time on a demo account, we can use several other strategies to help filter out unwanted emotional responses.
These include:
Setting clear and realistic goals and expectations for every trade. Each time you trade you should have a clear idea of what you are hoping to achieve from that trade.
Being clear about why you have entered the trade, what your target levels are and the timing of any macro catalyst, that could help you to achieve them, for example, economic data releases or earnings.
The prudent use of stop-loss and take-profit orders can help traders limit losses a maximise profits. However, stop-losses and take-profit orders are only as good as the person setting them- if you don't submit or respect them, then they won't be actioned.
Reviewing past trades and learning from your mistakes and successes we can do this by keeping a trading journal in which we track our performance and emotional state. This can be a very effective tool to look back on at the end of trading week or month, taking stock of what we did well, and what we did poorly.
The trading journal or diary also provides the opportunity to note down why we took a trade and what our expectations for it were, and whether we got tan expected outcome or something different.
Seeking feedback and advice from other traders or mentors plenty of people faced the same issues as you do when they started on their trading journey, and as a rule, more experienced traders are happy to share their advice and their experiences with you.
Thanks to social media and chat rooms the are numerous trading communities online that you can join and interact with. I belong to half a dozen myself and swapping ideas and information with fellow traders is a great way to learn.
Don’t be afraid to ask questions if you don't understand something, but be prepared to do some homework to broaden your knowledge base.
However be wary of get-rich-quick schemes, or those who claim to be able to teach you trade in say 5 easy lessons particularly if they are asking for big fees to do so.
Trading discipline can be taught but it is never easy to master and rarely learned quickly.
Developing a positive mindset and attitude towards trading, trading is stressful but by systemising our approach and following the rules we’ve set out in our trading plan, we can take much of the guesswork and associated stress out of the situation.
If you do find yourself stressing out, take a break - go for a walk or catch up with friends and family. Or even do some household chores, which should take your mind away from trading
Loss aversion in trading is a natural human response, but it can be detrimental to your trading performance and profitability.
By recognizing and overcoming this bias, traders can improve their decision-making process and in doing so achieve better results in the financial markets.
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