It does not matter whether you are reading sophisticated trading books or just browse around online trading forums, almost every trader seems to be aware of the fact that psychology has a big impact on trading performance. However, the way emotions affect trading decisions are very complex and not that obvious at the first glance.
When you think that biting nails, sweating or rubbing your hands greedily are the things that signal emotions while trading, this article will offer some valuable new insights. In the following we explain how to read emotions that affect your trading decisions and how to overcome the negative impacts that arise from emotion caused trading errors.
“Missed it! It had all the entry criteria going for it, but I didn’t like it somehow.”
Especially inexperienced traders or traders who find themselves in losing streaks often act like a stunned deer staring motionlessly into approaching headlights. The surest sign that fear is controlling your trading decisions is that even though you plan a trade and watch the setup unfold in front of you, you still doubt the trade and cannot pull the trigger.
If you notice that you constantly miss trades, although they meet all your entry criteria, you should decrease your risk. Eliminating the possibility to risk a substantial amount of money will usually help decrease the impact of fear-based trading errors. After you have gained confidence and trust your trading strategy you can slowly increase trade size until you find your threshold. Printing out your trading rules and checking them off one by one can also help with eliminating fear of entering trades.
“How could I have lost so much on this trade? It looked so good.”
The opposite effect will come into play if you find yourself losing disproportional large sums on individual trades. If you overestimate the predictive quality of your trading system, you are more likely to use a bigger than usual position and blank out the fact that trades will fail. Futhermore, traders who have a small trading account are more likely to risk a relatively large percentage on individual trades to grow trading accounts quickly. The dominant emotions in these scenarios are greed mixed with overconfidence and ignorance – a deadly combination.
The best thing you can do is to reduce trade size to avoid large drawdowns. You should set an absolute maximum risk level that you will not cross – no matter how good you think a setup is.
“I think it’s going to turn around. I just widened my stop loss order a bit. It is a good setup.”
This sentence is a continuation of the previous case. When traders believe that a setup is too good to fail, they are more likely to find reasons to avoid realizing losses by widening stop loss orders, adding to losers or completely taking off stops.
When you find yourself in a similar position, you are trading based on hope and ignorance. At this point you have already completely forgotten your trading plan and the only reason why you are still in the trade is because you hope that it will turn and you don’t have to take a loss. If you ever find yourself in this situation, immediately close your trade to be able to neutrally evaluate the situation.
“The trade looked so good. I thought it would move further and not turn around that quickly.”
A sure sign that greed is influencing your trading decisions is when you do not take profits, even though the price has already reached your take profit level. Although you might be able to get a bigger winner every now and then, what really happens is that you will constantly give back profits and cut your winners. Over the long term this can even turn a good trading system into a losing one.
Always stick to the plan you made before you entered the trade. Don’t listen to the greedy voice in your head that pops up once you are in a trade.
“The trade has already made some good profits. Maybe I better close it before it turns around again.”
This is the opposite scenario to the previous one. Whereas greedy traders will not realize profits because they hope to get more, fearful traders close trades which are in profits ahead of their take profit order because they fear that markets can turn any second.
There are several ways to overcome the premature closing of trades based on fear. The set-and-forget approach, where you close your chart after you opened the trade and set stop loss and take profit order might work well for some trading strategies. Don’t watch your P&L during trades because you will start worrying about every down-tick. Gain trust in your trading strategy over time and accept the fact that price moves in waves – retracements are, therefore, normal and should not be mistaken with reversals.
“It doesn’t have all the entry criteria just yet, but I still enter the trade now. I will not let this take off without me this time.”
Entering trades too early because you worry that you could miss a trade is another sign that greed is messing around with you. Your trading rules serve as a filter and their only purpose is to keep you out of those trades that have lower likelihood of turning into winning trades. Therefore, if you violate trading rules with the expectation to outsmart the market, you misunderstood the way trading works and are a victim of your greed responses.
To Sum It Up
As we demonstrated, the effects of emotions such a fear, greed and hope are often not obvious at the first glance, but manifest in trading decisions and result in poor judgment. Being aware of how emotions interfere with your trading is the first step and the premise to eliminate the impact of emotion based trading.
Hindsight Can Affect Your Emotional State
Emotions do not only play an important role while you are in a trade, but they can impact your emotional state and future trading decisions even after you have closed your positions.
“Oh, I exited too early and should have let it run – next time I will set my take profit further away.”
If you see that, after you closed your trade, price would have further moved in your favor, you are more likely to set wider take profit orders on the next trade. Setting wider take profit orders, without statistically validating that it will have a positive effect on your trading performance, can be a very dangerous thing to do. Usually, just randomly using wider take profit orders will only result in a lower winrate because price will turn ahead of your take profit order.
Traders who have a problem with greed based trading decisions are more prone to look back at trades and punish themselves for not letting it run longer.
“I knew it! I felt it was going up, even without meeting all my entry criteria. I should be more aggressive.”
Another problem that arises from hindsight knowledge is when traders see that a trade would have worked out even though not all entry criteria had been met, they are more likely to violate trading rules on their next trades.
How To Deal With Hindsight Knowledge
Hindsight knowledge is a very important thing in trading, especially when it comes to making improvements to your trading strategy and tweaking your edge, but the way traders use hindsight is completely wrong. Here are a few tips how to use hindsight to your advantage:
Evaluate whether you can improve take profit or stop loss placement looking back at trades after you have closed them
Analyze trades that you have missed and evaluate whether some of your entry criteria keep you out of profitable trades
If you have followed your rules, but see that a trade would have moved further, or entering a trade early would have made you more money, do not punish yourself. Instead, pride yourself for following your trading plan – religiously following your trading plan is a key attribute of a professional trader
Do not let the potential outcome of a single trade affect your trading decisions on your next trade
Think big! Collect hindsight-data and only alternate your trading strategy after you have a big enough sample size that will provide you with statistically significant information…!