Saturday, July 26, 2008

Pitfalls Encountered with Emotional Trades

At one time or another, most traders, including myself, have traded by emotion. In coaching sessions and in conversation with many traders over the years, I have seen countless examples of emotional trades and emotional trading. There has been one constant in those observations and it is that those who continue to trade with emotion without some discipline fail. Some of the emails I receive and some of the traders I meet seem to think about buying a stock as they might think about buying a lottery ticket. They go in with a euphoria, or at least excitement that they are going to hit the jackpot. More often than not, they have no exit strategy whatsoever, nor have they considered the risk or the potential reward to risk ratio.

As I set out in my book, "Trade Your Way to Wealth" successful trading involves some self-examination and planning. In the book, I talk about elements to include in the plan and the necessity of having an exit strategy before ever entering a position. Adherence to a simple plan designed for you can really give you a chance to become a better, more successful trader. In the following material, see if you see yourself in any of the examples and then ask yourself how did it work out? A coaching client told me that his failures came from "the little man behind the curtain." He pointed to the back of his head indicating that the "little man" was that voice we have in our heads.

A while ago, I was talking to a guy who told me he bought a stock because he "knew it would go up." Another fellow told me he was buying a stock because he thought it would go up. Neither went up. Each of those traders suffered real losses. What did they do wrong? They approached the trades in "Pollyanna" fashion, "knowing" or believing that the stock would move in a specific direction and ignoring a decision on where they would get out if they happened to be wrong on the direction. Why would they ignore the possibility that their stock would go down? My guess is there were two reasons: first, a case of mild euphoria about the big gain they would get (greed) and second, refusal to recognize, or at least sublimating, an unpleasant emotion -- loss. If we look at things rationally, wouldn't we agree that there is literally no stock that couldn't go down? (If there is, please let me know as soon as possible). Recognizing that any stock can fall in price not matter what we think it will do might lead us to agree that an exit strategy in the event we may be wrong on the direction makes sense. At a rational moment, we can decide exactly where we will cut our loss. If we fail to make that decision ahead of time, aren't we leaving things to our emotions and aren't we more likely to listen to that little voice in our head that says: "it'll come back" even as we go deeper and deeper into the red?

Another example of emotional trading I have seen is the person who grabs a profit as soon as there is one to grab. I've heard a trader say, I took the profit right away because I was afraid I'd lose it. After his exit, the stock moved another $30. The fear caused him to cut his profits and miss another $30 a share. His exit strategy was "the little voice" probably saying something like "Get out of this position, remember the last time you had a profit and you let it turn into a big loss. Don't do that again." Yank, the plug gets pulled. Would a more disciplined approach yield a better result? My guess is in more cases than not, it would. The idea is to cut losses, not profits and to let profits, not losses, run. A predetermined exit strategy such as a trailing stop as I discuss in the book, can keep you in the game through little retracements and market chatter while limiting losses in the event of a reversal. You can create your plan and then execute it so that you simply follow a pre-determined exit strategy. Does that mean you still won't have losses? No. Does it mean that you will always let profits run throughout their whole move? No. It means you are likely to improve your trading by limiting losses and giving yourself a better chance to avoid cutting profits early.

Trading is not about hitting the lottery. It is about having the gains add up to more than the losses. Successful trading involves giving yourself a little edge. The "hot reactors" of trading do not give themselves that edge. They tend to bet it all on black and though they might hit every so often, they are not giving themselves any edge. They are truly the gamblers while the pro traders make themselves the house.

Bottom line is it is your money and your risk so you are entitled to do it however you want. I prefer trying to get an edge, but I really appreciate the hot reactors; they make life a little easier for me.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved


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To comment on Bill's article click on the "comments" link below.

13 comments:

Anonymous said...

Bill,
As always, a very informative and useful newsletter. Please continue the good work.
As I have mentioned before, I am a 30+ year vetern of the stock brokerage business. I have helped clients make small fortunes. The problem is, they came in with large fortunes. I have seen the emotional trader and I have been the emotional trader. As you say, it rarely pays off. The most difficult thing to learn is, as you so correctly point out, to establish an exit strategy and then STICK TO IT. There is a tendency to second guess oneself and that leads to doubt and gives emotion a chance to return. What trader has not been upset when the stop is hit and a calculated loss absorbed and then the stock rebounds? It happens and it makes traders doubt their judgement. I recommend the "don't look back" tactic. Once an issue is stopped out or sold for a gain, forget it and move on to something else. After all, nobody bats a thousand.
The road to you-know-where is paved with "woulda, coulda, and shoulda".

dsb

Anonymous said...

Right on as usual Bill. I have only been trading for 4 years, and watched my trading account shrink month after month. Until I developed rules and followed them. Without discipline it's the same as going to a casino, but instead of the house having the edge, the market does.

Bill Kraft, MarketFN.com said...

Thanks, dsb. I agree that the second guessing traders do can really be harmful. I like to look at the trade as it closes and see if I honored my exit strategy. Generally, if I did it will have been a good trade even if it lost a little. If I don't follow my own strategy, it rarely winds up as a good trade. Beyond that, I definitely agree with the "don't look back" philosophy.
Bill Kraft

Bill Kraft, MarketFN.com said...

I agree Anonymous, and discipline seems to be the hardest part for most.
Bill Kraft

Bess said...

Trading and investing on emotion has always been a part of the financial services world

This emotion based investing, however, has been exacerbated in recent years with the advent of online trading. Nowadays, anyone with a few dollars and a desire to “play the market” can open an online trading account and invest to their hearts content. This is making today’s markets extremely volatile where investors can be ahead by 1% to 2% in the morning, only to end up 2% down by the market’s close.

To stay ahead in today’s market and avoid the heavy losses a casino investing mentality can create you need to have, as you say Bill: “…a simple plan designed for you can really give you a chance to become a better, more successful trader.” “Trading is not about hitting the lottery. It is about having the gains add up to more than the losses.”

Successful trading/investing is about sticking to a process and not trying to second guess the markets direction with “hunches” and “feelings.”

Bess
~I am an “Automated Process Investing” investor~

Bill Kraft, MarketFN.com said...

Thanks for your contribution, Bess.
Bill Kraft

Anonymous said...

Bill thanks for the emotional lesson. This is my problem. I just don't know when to sell, exit a position. I was up nicely in my oil stocks the end of May and had a feeling oil was going to correct and wanted to sell them. As they kept going down, I kept saying to myself how could I sell an Apache or a Hess. I rationalized by saying to myself they always come back and I should take a five year approach. That was not my plan at all. Now instead of being up nicely, I have paper losses. Thanks for the weekend newsletter, I found it very helpful.
Regards M. K.

Anonymous said...

Dear Mr. Kraft,

I have just become aware of your writings, which I think are great. I do want to comment on this post. I find nothing to disagree with, but I just wanted to let you know that I do disagree with the whole approach of “trading” as a way of investing, at least for me.

I am a retired small businessman, and my whole current income comes from my investments. I need to be conservative with my investments. I have defined for myself the world “speculation” as being the purchase of any asset, with the expectation that the price of this asset will go up, and one can sell it and make money. I do not think this is in any way investing, and I do not advocate it.

For one thing, since you can't really know which way the market is going, you shouldn't count on capital gains. Then, when you sell to take out money to live on, you are depleting you capital. This would be the same as buying a farm as an investment in a business, and then selling off little bits of land every year to live on. Pretty soon you would be in trouble. Plus, it gets even worse. The constant dollar averaging principle works in reverse when you are taking money out for retirement uses. If you have to disinvest a certain amount of money every month to live on, you are depleting your capital faster during periods when the market is down than when it is up.

No, I reserve the term “investing” as being this; purchasing an income stream. Purchasing a farm or business that has a historical record of profits. Purchasing a security that has a proven record of generating high dividends. These are what I call true investments. I invest exclusively in these types of investments, and I set back and live off the proceeds of these investments with no thought of selling them, or of running out of money no matter how long I live. I go for months and never even check what my portfolio is actually “worth”. It is irrelevant. My Canadian oil trusts and copper producers have a long history of throwing off high dividends, because they are business that have low capital requirements, and can use a small portion of their income to continually acquire new reserves.

I see you have a dividend section in your web site, but even here you talk about selling if the market value of your investment goes up. Perhaps for an active investor that is fine, but personally I like to just sit back, collect checks, and spend my life doing other things than worry about trading. Just my choice, everyone to their own.

Regards,
Richard T

Bill Kraft, MarketFN.com said...

Thanks for writing, M.K. My best advice is to have an exit strategy in place before you enter a trade. It can be a break in a trend line, a cross below a moving average, a break below price support, the crossover of a shorter term moving average beneath a longer term moving average (e.g. a 20 day crossing below a 30 day or a 10 day crossing below a 20 day or whatever you choose). Once the exit is hit, follow the plan and exit. I'm glad you found the article helpful.
Bill Kraft

Bess said...

Richard,

Yes there is a difference between trading and investing. Done right, both will get you results (key work here os done right).

Although your definition of investing "I reserve the term “investing” as being this; purchasing an income stream. Purchasing a farm or business that has a historical record of profits. Purchasing a security that has a proven record of generating high dividends." is an accurate one, you shoud always be open to diversification.

Now, you don't jump in 'hook line and sinker' but try to explore other venues of income producing and weath acumulation strategies available for today's investor.

Investing in the stock market is the easiest, most direct method of accumulating weath ever invented - yes, I would venture to say even better than Real Estate (I know this is controverial statement - and is just my opinion).

Bess
~I am an “Automated Process Investing” investor~

Bill Kraft, MarketFN.com said...

Thanks for your comments, Richard T. Interestingly, I am under contract to write finish the manuscript for my next book this year. It will address precisely the subject about which you wrote. I should note that the website is not mine and I do not edit the Dividend section. However, in my own trading, dividends are an important consideration as is selling covered calls which also is a form of trading and something someone like you can do with his own optionable stock holdings. I do disagree with the" hold forever" philosophy you advocate because some companies reduce or eliminate dividends. Often that occurs after the stock price has dropped significantly as well because of some problems with the company or industry. Companies in the financial sector are experiencing this phenomenon now. They may come back or they may disappear. I don't want to be holding an empty bag because a company used to pay great dividends even if they do disappear. As an additional safety net while still accomplishing things the way you have been you might consider collars as I describe in my book Trade Your Way to Wealth. That strategy is an investment strategy as you define it but adds an element of "insurance" to the investment and still lets you go about your life the way you want to live it. Incidentally, I congratulate you on finding a style and strategy that fits your personality. As you correctly point out: "everyone to their own."
Bill Kraft

Anonymous said...

I have been trading 2 mos....maybe 10 trades so far...and none of them without an exit strategy. Advantage of having a small cash account is that I KNOW I cannot afford to trade on emotion. That said, successfully managing losing trades isn't an erstwhile goal either! I have only profited on 1 of 10. The losses were calculated...but they came and over time they add up. So, I obviously have more to learn about "smart" trade prospecting.

William
Loveland

Bill Kraft, MarketFN.com said...

My guess, William is that most if not all your plays were bullish; that is, where you wanted the stock to go up. Since we are trading bearish conditions, it is very hard to find bullish winners. In general, I want to make my directional trades the same way the market is going. So bearish trades in a bearish market and bullish trades in a bullish market. Of course, my guess is just that -- let me know.
Bill Kraft