Breaking Bad Trade Behaviors
It can be difficult to keep emotions from upending our decision-making—especially when we have money on the line. The problem is particularly acute for stock traders, who can often find themselves in emotionally charged situations with considerable sums at stake.
Here's how traders can take a clear-headed, more-considered approach to four potentially fraught trading situations.
1. You're holding on to a loser
For traders, losing money can be more painful, emotionally speaking, as gaining it is pleasurable—a psychological effect known as loss aversion. Once an investor sees shares fall below the purchase price, they become reluctant to sell it because doing so would mean taking a loss. This reluctance could ultimately make losses worse if the stock continues to decline.
The fix:
A common trading maxim applies—cut losses short and let winners run. One way traders can do so is to create an exit strategy before placing a trade, such as setting a stop-limit order to automatically sell if the stock drops to or below a limit price—say, 5% or 10% below the cost basis. (Note there is no guarantee that a stop-limit order, once triggered, will result in an order execution.) Making this kind of upfront commitment can help remove your emotions from the selling process.
For positions a trader already holds, consider this: Would you buy the stock at its current price if you didn't already own it? If the answer is no, it might be time to sell.
2. You've had a string of losses
Losing streaks can happen to the best of us, but sometimes a bout of bad luck can actually reflect a problem with our trading strategy. Attributing successes to our own skills but failures to uncontrollable outside forces is known as self-attribution bias.
The fix:
To begin, traders should look at whether they're losing or making money on a net basis, then look for patterns in their wins and losses. For example, if winning trades employ fundamental analysis and losing trades are based on technical analysis, a trader might want to focus more on fundamentals for a while.
As a trader works to figure out what needs fixing, there's no harm in reducing the size of your trades. Once your results get back on track, you can increase your risk-taking.
3. The market is tanking
Few scenarios trigger hasty or irrational decisions quite like a massive market decline. As panic sets in, greed, loss aversion, and wishful thinking can all collide. Instead of performing our usual due diligence, we allow price alone to dictate our trade decisions, believing it's an opportunity for quick and easy gains. At the same time, we may double down on losing positions in the hope that the market will rebound quickly—and our trades along with it.
The fix:
First, traders shouldn't overlook the possibility that the downtrend could continue. Rather than getting into a trade while the market is plummeting (sometimes called "catching a falling knife"), a wiser approach may be to wait a few consecutive positive days for clearer heads to possibly prevail before opening a new position. And it's important for traders to do the usual homework on any stock they're considering—bargain-basement prices alone aren't reason enough to buy a stock.
" id="body_disclosure--media_disclosure--154786" >First, traders shouldn't overlook the possibility that the downtrend could continue. Rather than getting into a trade while the market is plummeting (sometimes called "catching a falling knife"), a wiser approach may be to wait a few consecutive positive days for clearer heads to possibly prevail before opening a new position. And it's important for traders to do the usual homework on any stock they're considering—bargain-basement prices alone aren't reason enough to buy a stock.
4. The market is soaring
Biases don't just rear their heads when we're under stress—strong bull markets, too, can trigger a host of suboptimal responses, including overconfidence, self-attribution, and herd mentality. In such cases, many traders let positions stay open too long, even when they've surpassed their profit targets. Some even cash out long-term positions to free up more funds to trade, potentially exposing themselves to unwanted risk.
The fix:
Above all, remember that gains aren't gains until a trader closes out the position at a profit, so some traders wouldn't let a trade stay open too long.
Traders should also keep an eye out for red flags that might lead to a reversal. It can be tempting to take on more risk when prices are rising, but doing so can leave you overexposed if an unexpected reversal occurs.
And finally, traders should take care not to risk too much of their investment capital in their trading portfolio. Many traders like to set a limit, such as not taking positions that represent more than 20% of their overall taxable portfolio.
Wait and deescalate
The point here is for traders not to become a robot but rather to remain on the lookout for those times when emotions can get the best of us.
If a trader has trouble distancing their emotions from their trading decisions, it's never a bad idea to slow down or even take a break. Cooler heads usually prevail, and trading is no exception.