Emotions get the better of traders

Traders can invest significant time and energy in developing a great strategy and studying the markets, but their human psychology and instincts will always work against them

People new to trading often first try their hand at demo accounts or paper trading. Using play money, they can simulate real trading using platforms that track the movements of markets. Once they’ve learnt how markets can move and have a feel for how the platform works, they then make the transition to trading with real money.

Very quickly, however, many realise the trading strategy they developed in their test runs is seemingly not working as well as it did when they weren’t trading real money. They may be making gains on most of their trades, but they’re losing money overall. The reason is simple yet not necessarily easy to realise in the moment: emotions kick in.

When you’re not risking real money, it’s far easier to be sanguine when you’re not doing so well. But when real money is suddenly at stake, human reactions to success and failure change drastically. Successful demo traders can find the transition very difficult.

“Human emotions influence how people trade and respond to markets,” says Chris Beauchamp, chief market analyst at IG. “Because of the way humans are wired, their initial perception is a trade that makes money is good and a trade that loses money is bad. There’s a sense of you against the market that makes remaining calm hard to do.”

A run of small loses sparks an instinctive need to get back what was lost by trading in a bigger size. If losses then continue, there is an even greater desire to catch up. Trading too big or placing too many trades to win back money is a common mistake and is seen in both leveraged and non-leveraged trading accounts as well as traditional shares trading.

Mike Tyson famously said everyone has a plan until they get punched in the mouth. In trading, everyone has a plan until they’re floating a major loss

Most humans have this natural tendency to snatch profits and run losses. Successful traders turn the rationale on its head, cutting their losses short instead and running their profits. They understand they can experience more losing than winning trades yet still make money if the profits on the winners exceed the losses on their losers.

In Michael Covel’s famous TurtleTrader experiment, which trained novices in the science of trading and then gave them each $1 million to invest, those who followed the rules they were given were more successful than those who didn’t. The study exposed the common human failure to follow rules when your instincts are telling you something else. In trading, those instincts are the feeling that comes from a run of wins or losses.

“Humans are wired to be risk averse so when you start seeing losses of an account you worry. And a run or two or three big winners is almost as dangerous to a trader’s psychology because you can get a sense that you’re not like everyone else, and you’re not bound by the rules, and everything you do will turn to gold,” says Mr Beauchamp. “That’s when reality catches you up and you wipe out all the money you’ve made.

“You don’t need to be a financial genius to look at a chart and say whether it’s more likely to go up or down. It’s not that they can’t see what’s in front of them, but the elements of fear and greed, which is what governs markets, really come into play when you’re trading. People hope their losses will get smaller and fear their winners will get smaller. You have to turn that around – fear your losses will get bigger and hope your winnings will get bigger – so that you get the appropriate risk-to-reward ratio.”

Many people go into trading thinking they need to win eight or nine times out of ten to be successful, but IG Group data shows they have to be prepared to take five or six small losses, sometimes in a row, to get just the two or three big winners needed to improve their account position. Crucially, too many people also think trading should be exciting.

“Humans’ attentions stray from what works because they seek out excitement,” says Mr Beauchamp. “To be a successful trader, you need to be able to ignore that temptation. Instead, find something that works for you and once you’ve found it, you have to stick to it. It’s a learning curve and people need to experience that to then start to improve.”

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Three tips for successful trading

Trade in the appropriate size

If you’re worrying about a trade, you’re probably trading in too large a size. A good way to help combat emotions is to reduce drastically the amount you’re trading with in terms of your position size so you’re not seeing big swings in your profit and loss. Your emotions will calm down as a result. It’s a good rule of thumb to say if you’re constantly checking your trading account every five minutes or so, you’re probably trading either too much or in too large a size because you’re worried. Take a deep breath and slow down; you’ll have more time to react to problems when they arise.

Keep a trading diary

Whatever your trading strategy is, make sure you always have those rules to hand so you can refer back to them. It’s a bit boring, but it’s a good way of looking back and showing where your winners and losers were and what happened after each of them. If you can identify where your trades followed the rules and where they didn’t then that also helps you maintain an emotional balance. Nobody wants to be reminded of their losers, but it’s a good process to learn. A trade might make money, but if it didn’t follow any of your rules, it was a bad trade. Similarly, be disciplined enough to know that a losing trade that followed your rules was not a bad trade.

Automate some of your processes

There’s no strategy that will work all the time, but if you use some element of automation, you can be better at following the rules. You can set preset limits for where you want your stop loss to be in terms of distance. That will help with your trading. The more you can automate some of the processes, the better you will be. The successful trader should eventually get to the point where it ceases to be exciting and becomes boring and routine, rather than having everything as a stab in the dark and hoping it will be successful.

Q&A: Why you are your biggest trading pitfall

David Rodriguez, senior currency strategist at DailyFX, IG Group’s research arm, delves into the data to expose exactly what causes traders to lose money

Which attributes make traders more successful than others?

Discipline is sine qua non of successful trading. Discipline and work ethic give you the drive to perfect your craft and create an effective trading strategy. Critically, discipline also helps avoid the most common cognitive biases which make trading quite difficult. Poor money management is the single biggest mistake traders make. Traders rightfully spend most of their effort picking good trades, but even the best trading system will have losing trades. Unfortunately, many traders will let those losing trades overwhelm any profits from trading on the winners.

What kind of insights do we have into trading behaviour?

The DailyFX research team looked through anonymised trading data from over 100,000 IG Group live accounts and tens of millions of real trades. We found that, on average, traders close over half their trades at a gain, but lose money overall. They lose significantly more money on their losing trades than they make on their winning trades. As an example, in 2016 IG Group’s clients closed 64 per cent of all FTSE 100 trades out at a gain, but the average losing trade was worth 35 points while the average winner was only 15 points. They were correct nearly two thirds of the time, but lost more than twice as much on their losing trades as they earned on their winning trades, and this pattern was reflected across all popular markets.

How can we explain this kind of behaviour?

Human psychology makes trading difficult. The growing field of behavioural economics posits a number of innate cognitive biases which get in the way of success. It is controlling our emotions which allows us to overcome these natural handicaps and prove successful at trading. Clinical psychologist Daniel Kahneman won a Noble prize for his work on behavioural economics and specifically the psychology of decision-making. The crux of his seminal work on Prospect Theory is that humans do not make rational decisions when faced with prospective gains and losses. We tend to feel much more pain when we lose than pleasure when we win. Extended to trading, it feels good enough to take a small profit on a winning trade. But when it comes to losers, we are unwilling to cut a loss short as the pain would be too great. Instead we allow losses to grow too large until we are ultimately forced to close the trade.

Do you think traders are aware of how much their emotions are negatively impacting their trades?

Psychology is generally underappreciated in trading. It’s certainly the exception, not the rule, that traders immediately identify their psychological limitation without somebody else presenting the evidence. When you show them the data and demonstrate the simple crux that we’re too willing to hold on to losses and cut profits short, there’s always an “aha” moment. A little bit of guidance goes a long way.

How can traders overcome the emotional factors that are causing them to lose money?

The prognosis is the straightforward bit; the prescription is more complicated. There’s no one size fits all. I like algorithmic trading because when I make buy and sell decisions manually I do foolish things and fall into the same traps as everyone else. If you lack discipline then maybe you should also look at automating your strategy, but there are plenty of decisions to be made on algorithms and the psychological pitfalls are comparable. At the very least, be mindful of your limitations, have a clear vision of what your trading strategy is and stick to your plan come what may. Mike Tyson famously said everyone has a plan until they get punched in the mouth. In trading, everyone has a plan until they’re floating a major loss. Adding structure to your trading is critical to controlling emotion. An easy example is using maximum loss levels and profit targets on each trade, guaranteeing you will not lose more than you stand to gain.

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