If you peruse the amount of trading books available for purchase you will notice one major recurring theme: the emotional aspect of trading. Is this because emotional people like to trade? Hardly. I don’t consider myself to be a particularly emotional person and I like to think that I can control my behavior in most situations despite being uncomfortable in social settings. Before actually trading I had figured like many people that as long as you were trading solid setups that made profit more times than not – why would you need to read about the emotional aspect of trading? Trading should be like playing a game of Tetris that is fun and interesting – but not emotional…right? Wrong!
If you have not yet experienced day trading let me walk you through a typical trade and the emotions you will feel. In this example we will be entering a stock long and selling for profit. The stock has recently been in a downtrend but has now just broken up past your downward trendline. Look at the chart below, Oracle, to see what I mean.
After a lengthy free-fall the stock rises strongly for a three bars (the three white bars near the end of the red trendline). You imagine that this stock will now soar straight upwards and you are missing out on the trade of the week. Does this happen? No. The stock goes one penny higher than the last bar and you buy 500 shares. But now your stomach is churning and you are starting to second guess yourself – did you make the right decision? You feel so uneasy not knowing what will happen next and suddenly that great looking pattern starts to look ugly. Next, the stock begins to drop hard! Over the next 15 minutes you watch as prices drop 11 cents and your account is down $55. You blame yourself for being such a fool and you feel frustrated.
- The stock is hitting new session lows – how far could this fall?
- Is this merely the start of a second massive leg down?
- Why did the stock reverse the moment you put your money into it?
The stock seems to know what you are doing as it reverses direction the moment you make a trade. Aha! A moment of genius hits. If you go long and the stock goes down – play the reverse game. You get this brilliant idea that no matter what you are thinking of doing - you will do the opposite and this will make money. If your gut is always wrong – then simply trade against your gut to make money…right? You quickly sell your shares at a $55 loss and you feel immediate relief from closing the trade despite losing money. But that’s not all - you are about to teach that stock a new lesson it won’t soon forget. You wait for 10 minutes until one of the bars drops below the previous bar in a new low and you short 500 shares while chuckling to yourself. Yes, if buying was bad than shorting is good – right? Within minutes the stock reverses direction again and goes up fast. Now you are good and mad and will punish this stock for its insolence and disrespect. No more switching directions – you have a new plan to execute.
As the stock rises you begin averaging your cost by shorting more and more. The stock has to reverse directions eventually and you will keep building your position so that when it does reverse you be aligned correctly. Soon you have 1,000 shares shorted and you will make a killing if prices will only go down to the daily lows. You start yelling at your screen, “drop stock drop!” The stock is showing no signs of slowing down as it continues to trade up. Now you are down $150 as you close the trade and blame yourself for being so stupid...how could you go against your trading rules? What just happened, you wonder. You come up with a ‘market manipulation’ theory about why you lost out on this trade. Do you want the truth?
You lost out on this trade because you ignored your trading rules and begain to make decisions based on emotion – nothing more and nothing less. If you keep this up you won’t know when to quit until your trading firm shuts your account down for the day due to the huge losses. Does that story sound familiar to any of you? It happens time and time again. Here are a few ways to control your emotions that should reduce the amount of bad decision making.
Remember That a Trade is Just a Trade: Trading is a game of probabilities. Your goal is to be right more than 50% of the time with your wins slightly larger than your losses (or even being right more than 33% of the time with your wins being more than twice the size of your losses). This is simple mathematical probabilities. Think of trading as a game of rolling a die. If you roll the numbers 1,2,3 or 4 you get a dollar. If 5 or 6 are rolled you need to pay a dollar. If you rolled 5 or 6 a few times in a row would you start yelling at the die, begin a pattern of self-depreciation or engage in any other sort of irrational behavior? What would be the point? You fully expect that a certain percentage of your trades will not work out when rolling the die – those are the odds. You also know that if you continue to roll the die long-term, things should swing back in your direction.
But why do trades not always work out if you have good setups or highly probable patterns? The same could be said of buying shares on a long-term basis – if you own a solid company, why do prices sometimes reverse? In the share market, things rarely stay the same – they are in a constant state of flux. With day trading, you might see a nice pattern developing and enter long into a trade. Unbeknownst to you, a certain fund needs to rebalance and they sell a large position. This kills the setup. Or maybe the market is jittery based on poor employment numbers and the market breaks down which will take your stock with it. Was the pattern or setup faulty? No, but things changed. We are trading a stock in the midst of a dynamic environment where updated information, news, new market participants and changing sentiment will greatly affect how a stock trades going forward. The setup could have been rock-solid at the point of entry but some other force can just as easily tear it down based on changing circumstances. A setup is just a setup at that point in time but conditions can, and will, change. A trade is just a trade and in no way does it reflect on you as a person or your intelligence.
When you earn profit, tell yourself that it was just a trade. This was not the result of some great stroke of genius whereby you can now beat the market at its own game anytime – anywhere. When things go badly you should tell yourself it was just a trade. You are not stupid or foolish or worth any less than you were yesterday. You had a good setup based on probabilities but it went the other way. See the theme here? A trade is just a trade and you need not take it personally. But what are some other practical steps you can take to control your emotions? That will be covered in the next article.