Emotions in trading and how to control them

Emotions in trading and how to control them

Humans are emotional beings. Good news makes us happy, bad ones cause sadness. We feel proud of our successes and regret our mistakes. We may be thrilled to see a celebrity on the street and would fear missing our flight if we leave the house too late. Given that emotions have such a central place in our life experience, it should come as no surprise that they influence our trading behavior as well. In this post, we cover emotions in trading in detail. In particular, we address a number of important questions: Why are emotions important in trading? Which emotions do traders go through during a market cycle? How do I control my emotions in trading?

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Why are emotions important in trading?

As we discuss below, there is ample evidence that emotions affect trading activity. More importantly, even market prices may be affected by investor emotions from time to time. In his book Irrational Exuberance, Rob Shiller, a Nobel prize-winning economics professor, points out that “the emotional state of investors when they decide on their investments is no doubt one of the most important factors causing the bull market” that took place in the late 1990s.

Pride, regret, and the disposition effect

There are a multitude of studies that provide evidence that emotions affect financial decision-making. For example, emotions in trading offer a potential explanation for the disposition effect, a commonly observed trading behavior. The disposition effect is investors’ tendency to hold on to ‘losing’ stocks while selling ‘winning’ stocks more easily (losing and winning are relative to the purchase price).

In a seminal paper, Shefrin and Statman (1985) (full reference at the bottom of this post) argue that feelings of pride and regret can be instrumental in generating the disposition effect.

In particular, selling a stock at a gain gives the trader a source of pride. After all, the trader can boast to his colleagues about his profits and how he made such a wise investment decision.

In contrast, selling a stock at a loss brings pain to the trader. The trader would most likely regret buying the stock in the first place and would find it difficult to report his losses to family members and friends. Therefore, he might as well hold on to the stock with the hope that it would gain in value eventually.

Greed, fear, and risk taking

Figure 1: Emotional trader – greed and fear

Greed and fear are two other important emotions in trading. They can have a significant impact on risk-taking by distorting an emotional trader’s assessment of the true probabilities of events happening.

For example, traders can end up chasing stocks that would yield stellar returns if events X, Y, and Z all happen at the same time. Of course, the probability of all of these three events happening might be very small. But, a greedy trader might end up exaggerating that probability and, thus, heavily invest in such stocks instead of solid stocks that yield consistently good (but not stellar) returns.

The reverse is true as well: A fearful trader may shun good stocks if they exaggerate the probability of a certain event that would cause those stocks to nosedive.

Overall, greed and fear can harm traders by causing them to exaggerate the probabilities of rare events.

Be fearful when others are greedy, and greedy when others are fearful.

Warren Buffett

Emotional trader: 14 emotions in trading over a market cycle

Emotional trader - 14 emotions in trading over a market cycle
Figure 2: Trading psychology through boom and bust

Trading can be a nerve-breaking experience for beginners. Emotional traders would go through a full spectrum of emotions ranging from euphoria to despondency over the course of a market cycle. In fact, that are 14 emotions in trading that traders commonly experience as markets rise and fall.

As the market begins to rise, traders are filled with optimism about the upcoming bull market. This would induce them to invest more in the stock market. As prices rise, they are full of excitement. They continue to purchase stocks, fuelling prices even higher. They experience the thrill of watching the market index rise and their portfolio values grow on a daily basis. And, they enter into a state of euphoria as the market reaches historic highs.

But, suddenly, the market stops rising, and the market index begins to go flat. At this stage, anxiety kicks in. Is the party over? Has the peak been reached? No, it cannot be, cue the denial: Ok, maybe the forecasts are not as good as before, but surely nothing fundamental has changed! Those economists warning about a downturn are simply too pessimistic! However, the coming weeks bring nothing but bad news. Traders are now surrounded with fear as they see their profits erode. They wait in desperation to see if things will begin to recover. By now, most of their previous gains are lost.

Panic begins as markets continue to fall. This is the stage that is emotionally the toughest. Most traders feel helpless, and there is a sense of total loss of control. Capitulation occurs as traders admit defeat by agreeing to sell their stock at any price to cut further losses. With an air of despondency, some traders quit the market and never return.

By now the worst is over, but traders are in depression, regretting their mistakes and feeling the pain of their losses. This lasts until the signs of a positive outlook gradually begin to emerge. Traders dare to hope once again. A relief sets in as market conditions continue to improve, and a new cycle begins.

How do I control my emotions in trading?

So far we have discussed the range of emotions traders go through and how emotions can have a detrimental effect on trading performance. Given the negative impact on performance, it is important to take emotions out of trading. While managing emotions in trading can be hard, especially for novice traders, we present several tips that might help to stop emotional trading.

Tip #1: Understand your risk appetite and manage risk accordingly

Many of us dislike risk and want to be rewarded for accepting risk. However, the degree of risk aversion varies among traders. Some traders might be willing to bear more risk than others. It is important for you as a trader to bear no more risk than you are comfortable with. This would largely preclude you from being at the mercy of your own emotions during volatile markets.

Tip #2: Develop a routine/plan and trade accordingly

It is easy for emotional traders to get carried away when markets are moving fast. You might feel the pressure to act quickly by buying or selling a stock. While timely decisions are of course very important, it is not necessarily wise to jump on to a particular trade out of emotions such as fear or greed. One way to stop that from happening is to discipline yourself to follow a routine or plan before submitting trades.

This would add rigor to your trading behavior and help you focus on fundamentals rather than fads. Of course, your trading routine does not have to be set in stone. It can be gradually improved as you gain experience. It is its existence that really matters.

Tip #3: Reflect on your trading successes and losses

An important learning mechanism for every trader is to evaluate past performance as objectively as possible. Rather than boasting about past profits, some of which might be due to pure luck, check if a certain strategy consistently led to success. Also, instead of simply regretting decisions that yielded losses, try to spot if a certain type of reasoning commonly led you to buy losing stocks. This approach would help you detach from the emotions of pride and regret and support you in delineating the trading actions and strategies that pay off.

Tip #4: Recognize revenge trades before submitting them

When losses occur, it is natural for us to have a strong drive to recoup those losses as quickly as possible. Unfortunately, this might rush us into revenge trades. Such trades are often not carefully thought out and might involve higher levels of risk than we would normally want to bear.

Tips #1 and #2 serve to prevent revenge trades. If you are about to submit a trade without following your routine (tip #2) and/or the trade involves a level of risk higher than what you are used to (tip #1), then there is a good chance that this is a revenge trade. You should also be extra careful about the trades you are planning after suffering losses as these trades are the usual suspects for revenge trades.

Recap

In this post, we have explained through examples how emotions in trading can have a negative impact on trading performance. In particular, we have discussed that pride and regret can lead to the tendency to sell winners too early and ride losers too long (i.e., the disposition effect). Moreover, greed and fear can impair our risk assessment through an overreaction to low probability events.

We have also covered the “14 emotions in trading over a market cycle”, which range from the euphoria felt at market peaks to the despondency experienced when markets hit the rock bottom.

Finally, we have offered tips for emotional traders to help them manage their emotions in trading. Briefly, it is important for traders to understand their risk preferences, stick to a routine when making trading decisions, reflect on their trading performance, and refrain from revenge trades. All of these tips would help them stop emotional trading.

Further reading on emotions in trading

Shefrin and Statman (1985) ‘The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence

What is next?

This post is part of our free course on trading basics. In the previous post, we explained what stock liquidity means and discussed different aspects of liquidity.

If you have any questions about this post, let us know by leaving a comment below. We would be happy to hear your suggestions as well. And, if you enjoy reading our content, please spread the word by sharing it on social media.


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