Saturday, June 14, 2008

Identifying the Emotion in Trading

Most of us have learned that emotions can be a serious enemy of successful trading. Unfortunately, all too often, trades are entered and exited solely because of emotion. Thoughts like "if I buy XYZ, I'll make a bundle," or "XYZ went down 50 cents today, I better get out" are examples of entering for greed and exiting for fear without any pre-planning or underlying discipline. I have often thought and am personally convinced that in the short to medium term at least the markets are ruled by the psychological rather than the logical. In my book, "Trade Your Way to Wealth", I place great emphasis on the need for discipline and the need and content of a plan. It is my contention that a trader can give himself or herself a better edge if they will follow the old adage of "plan your trade and trade your plan." To me that means map out the whole trade including the complete exit strategy before you ever enter. In that way, we can lessen the emotional pull and give ourselves a better chance.

After I sent out an alert recently, I received an email from a subscriber who advised that the stock I was trading was on his brokers "restricted list" that required a customer to call in and that made the subscriber "nervous about the trade." That email raised several important issues about trading. The first thing that jumped out for me was that I don't believe anyone should enter a position that makes them "nervous." When someone says he is nervous about a trade, it tells me that emotion is already operating in high gear -- the trader is afraid of losing and that fear is already in control. The nervousness is easily avoided. Either don't trade, or at least don't make that particular trade. The real question is how to remove the nervousness from the equation. The best way, in my view, is to have an exit strategy in place before ever entering the trade; know ahead of time where you are going to cut your loss before you get into the position. Every trade can lose so discipline the trade to cut the loss where you have made the determination ahead of time.

The next issue the email raised for me is who is the subscriber listening to and why? He was concerned because his broker had the stock I was discussing on some list that prevented the trader from making the trade on the internet and required him to make a phone call to place the trade. I'm not sure that the simple fact of having to make the call and talking to a live broker was the problem for this fellow or whether it was because he perceived some other negative from the requirement. One way to find out, of course, is to call and ask the broker why they have that stock on the "must call" list. It may simply be because it was a cheap stock. One of my brokerages requires me to enter a special PIN when trading the real cheapies, for example.

As I pointed out to the subscriber in my response to his email, many times analysts differ on their opinion regarding a stock. Where several analysts are covering a stock, it is quite common to have differing views sometimes as wide ranging as from strong buy to strong sell and anywhere in between. There is a disagreement every time an order is filled since the buyer expects the price to go up and the seller doesn't. That is why it is important for the individual investor to educate himself and make his own reasoned decision regarding entry to or exit from any position. There is, as I have often written, no holy grail of trading. No commentator, analyst, broker, or system is going to be right all the time. Trading is a business that is inherently risky. As I describe in "Trade Your Way to Wealth", understand the risk, exercise sound money management, be aware of reward to risk ratios, have an exit strategy and plan your trade. If you don't do at least those things, you have every right to be and should be nervous about all trades.

For the record, I closed the trade that made my subscriber nervous in just 6 days and realized a before commission gain of 3%. Of course, it isn't always that way. The key is to prevent your emotions from ruling the trade.

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

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Bhoomi Trader said...

Emotions are dangerous to a trade. Your article very simply explains how to identify emotions and this is the first step in tackling it.

bills1040 said...

I like finding a stock that cannot be filled via the Internet. Maybe, I have had some luck that has been co-incidental to that issue but for whatever reason, I have done about 50% better on stocks purchased on Etrade's "restricted" list.

The equity I have been in and out of a few times is listed on Nasdaq, sells between $5-$10, and is not as thinly traded as many I have no problem purchasing on line.

It has a good deal of LED exposure, a technology I thought was going to take off when energy costs were half what they are today.

Anonymous said...

you often talk about exit strategy and also often have a covered call play; i've never seen you talk about the two together; do you think a stop loss on a stock that you've done a covered call on is a good idea?

Bill Kraft, said...

Great question on whether having a stop loss on a covered call stock. As is often the case, if you are a buy and hold investor, probably not. However, the pure covered call strategy is bullish so if a stock is falling, a trader may very well want a stop in place so the loss in the stock doesn't become too large. Of course, the call position would also have to be closed otherwise, once the stock was sold the trader would be in a naked call position with the attendant relatively very high risk. Thanks for writing.
Bill Kraft

Bill Kraft, said...

Good point, Bill. Just because a stock is on someone's "restricted list" doesn't mean a trader can't or shouldn't take a position. It means that the trader should investigate before leaping into a position which is what he should do anyway. Thanks for your contribution.
Bill Kraft

Bill Kraft, said...

Thanks, Bhoomi Trader.
Bill Kraft

Anonymous said...

You are so right about emotion driving so many trades. I always think of your wisdom before I make a trade by asking, is this in keeping with my original plan, or am I panicking or following the crowd?
Mark L.

Unknown said...

hi Bill

It was really fantastic information. Yes, i would say that most persons trade without really having the knowledge of trading game. Emotions really has no place in trading and i already thought this to be true but when somebody having a good amount of knowledge shares the same with you, it becomes more stronger than before.

so, very much thanks for sharing this with me.
I would be elated to hear these kind of articles from you regularly.


Anonymous said...

Bill, You said, "The first thing that jumped out for me was that I don't believe anyone should enter a position that makes them "nervous." Knowing that any stock one buys can be clobbered via short selling by hedge funds, should make anyone nervous. So, give us a sample list of stocks that cannot be touched by the hedgees. Keep in mind, naked short selling when preparing that list. Thanks, Nervous Sal

Bill Kraft, said...

Nervous Sal, one way for the very nervous to protect themselves is to buy protective puts on stocks they buy, or protective calls on stocks they short. Disciplined exit strategies also have worked very well for me and, by that, I mean an exit strategy that is determined before a position is ever entered, not one that is reactive afterwards.
Bill Kraft

Bill Kraft, said...

Thanks, Balmukund. Glad to hear you enjoyed the article.
Bill Kraft