When you look at the charts after the face everything looks 20-20 and you want to smack yourself for missing a good trade. This is known as Hindsight bias. The problem with hindsight bias is that we are selective. We only use selective information that validates what we now know to be true and we ignore other facts about the event. Uncertainty is part of the trading game. We are always ambivalent about the market reaction. Suppose we think that the market will be bullish. Now suppose the market infact rallies. We are affected by the hindsight bias and have a 20-20 vision. Wasn’t I sure the market will rally. Now we are not talking about the ambiguous situation we were in before the market rallied. We were not sure what would happen. But with hindsight bias we simply ignore this fact. Hindsight bias results in a feeling of regret. We regret that we had ignored a strong signal and let the market rally. Next time we can take a marginal trade thinking that we missed a good move last time and this time I am not going to miss it. Another problem with hindsight bias is that it inhibits learning. You knew it would happen like that and this means you don’t need to analyze the new situation deeply.
Endowment Effect
You should also be aware of the endowment effect. You buy Apple stock at $500 per share. You make your analysis and think that Apple price will go above $780. You set $780 as profit target. You also buy new iPhone and are very confident that Apple stock will rally as the new iPhone is getting raving reviews and selling hot in the market. Everyone wants the new iPhone model. Sure enough, Apple AAPL rallies and reaches $700. Now the charts are showing a bearish double top pattern and you have all the signals that AAPL has reached the top and now it is going to reverse. But you ignore the sell signal and wait for AAPL to go above $780 which it never does. Now AAPL is trading around $500 again and you are still holding it. Endowment Effect is the exact opposite of cutting a winning trade short. You expect the price to go above $780 and simply ignore the market signals that AAPL rally is over for now. Endowment Effect is part of our brain setup and it simply means we don’t want to give up what we possess. It is always painful to lose something of value. This pain triggers the endowment effect. Endowment effect also can compel traders to convert a short term losing trade into a long term trade.
We as traders make unforced errors better known as cognitive errors. We are used to using heuristics also known as cognitive shortcuts in our everyday life. But these heuristics don’t work in the uncertain environment of trading. These cognitive biases are mental blind spots and as trader we should know them. Emotions are just the way we think. Understanding how our brain thinks can help use better manage our emotions. Trading psychology is important for a trader. We cannot control our emotions but being aware of these cognitive biases can help us better understand how our mind thinks and make decisions. This can help use manage our emotions. We need to ask disconfirming questions before we make a trading decision. This helps us avoid confirmation bias. You should develop a set of disconfirming questions that can help you avoid confirmation bias and the hindsight bias. Recency effect happens when we pay much more attention to the recent price action and ignore the bigger timeframes.
Is your trading being effected by strong emotions? Strong emotions always result in erratic trading. You can suffer a losing streak if you cannot manage your strong emotions. You can also suffer by taking early profit if you are facing strong emotions in your mind. When you open a trade, suddenly you feel a rush of strong emotions and your heart starts beating faster, your nerves become edgy. You constantly watch the chart and your emotions urge you to close the trade immediately when their is a small profit before it turns into a loss. Fear and anxiety becomes a challenge for most traders. Most of the time you will find that trading is highly uncomfortable. Experienced traders learn over the years to still take decisions when they feel uncomfortable about the market. Fear and anxiety can cause erratic trading behavior like closing a profitable trade too early or not taking a trade even when we have a solid trade setup. Most of the time we are experiencing threat of a trade loss, we are afraid that the stop loss will get hit.This causes anxiety and raises the stress level in our body and mind. Now this fear is coming from our mind. Unforced trading error is an error that has been caused by the trader and could have been prevented. Opening a trade fearing that the market is about to take off only to find price reversing and hitting the stop loss is an example of an unforced trading error. Taking an impulsive trading without any planning is an example of an unforced trading error. Impulsive trading is always caused by fear.
I cannot afford to lose another trade. A big winner can cause euphoria and overconfidence. A losing trade can make the trader overcautious. If the trader is less experienced his trading can nose dive on taking a loss. They refrain from trading trades and reduce the trade size. If your trading is suffering from a strong emotion of fear, you will cut the winning trades short, fearing the market will turn and take back the profit. You will also place tight stop losses so as to avoid big losses. Hope and greed are another two emotions that may not be independent but generated by the underlying sense of fear. Not closing a losing trade on the hope that the market might turn and trade again becomes green and profitable. Some traders on losing become angry and open another trade impulsively without any planning hoping to recover the loss. When they lose again, they start shouting and some even spit on the computer screen. These are all strong emotion based behaviours.
On losing again and again, emotions start controlling us. We can hear voices like you will become a good trader, you have done it again or you are stupid and you will never learn trading appear in your mind again and again forcing you to withdraw from trading. Negative self criticism is never good. Instead of thinking that you will never learn trading, focus on your mistakes and tell yourself that you jump into a trade too early and next time you will be patient and wait for the entry signal to trigger your trade. Emotional hijacking takes place when you make decisions without planning solely based on your emotions. Initially confidence is high and risk is totally ignored. When the trade fails to work, emotions take over and the trader becomes fixated on the chart watching each tick. Falling under the spell of emotional hijacking means we lose emotional intelligence EQ. You might feel sad when you lose a trade. Your mind starts criticizing and you might feel as if you are no good and you are worthless. EQ can help us manage our emotions. The best method to manage feelings of fear arising when you are trading is to recognize the early signs and symptoms of fear.
How to deal with strong emotions?
These are the four forms of fears that you will experience as a trader. Being wrong, losing money,missing out and leaving profits on the table. How to deal with strong emotions? The three methods primarily used by traders are: 1) Improving the technical analysis. 2) reducing the losses. 3) trying to improve psychological control of emotions. Improving on technical analysis is a good thing. By reading the charts better we can make better trades. When you lose a trade, you think that in future more information will help avoid a bad trade. When you are looking for more information before opening a trade, you are in fact trying to control your emotions with more information. More information will simply not solve the problem of emotions. If your trading strategy has a statistical edge it will work despite your feelings due to its statistical performance. Adding more indicators and more information will not improve the statistical performance of your trading strategy. Extra information does not improve decision making many studies have shown this. Extra information just causes you to focus on your confirmation bias. Extra information is used to confirm an already taken decision. More information cannot help solve the problem of uncertainty and incomplete information in trading. We should accept the feelings of uncertainty. Fighting these emotions with more information is an elusive dream.
The second method that traders use to control emotions is trying to avoid losses. But this is also not a good solution for controlling the emotions. When we try to avoid losses we become rigid and tend to forego good trades. Losses are emotionally more damaging than winners. If we have a series of small losses, it adds up and we can feel very bad perhaps even devastated. Losing a series of trades can prompt us to cutting winners shorts which is also not a good thing. When we are cutting the winning trades short we are infact taking a small profit instead of a big profit. This is also known as the Disposition Effect. Instead of focusing on a single trade we should focus on winning percentage in a group of traders like 30 trades. If you win 5 trades in 30 trades, you are all set if your winning trades make 10 times more than average losing trade. If you feel uncomfortable in keeping a trade open and close it early taking a small profit instead of letting the profits run, you are a victim of loss aversion and you are ensnared by disposition effect.
The third method of trying to psychologically control your emotions is also not going to work. If you are trying to psychologically trying your thoughts, emotions and feelings you are just making your problems worse. If you keep on telling yourself that you cannot take another loss, you are trying to suppress your thoughts and emotions which will shortly reappear in a different form.