Introduction
As much as we like to think of ourselves as logical and rational when we make decisions, our emotional state is a big driver in our behavior. Emotions influence decision making, both for better and for worse. Here we explore two strains of emotions- anticipated, and immediate, and their impact on trading.
Anticipated v Immediate motions
Anticipated emotions, driven by the envisioned consequences of a decision, can significantly impact trading behavior. For instance, the anticipation of replicating the excitement of a recent winning trade may drive a trader to impulsively enter a new, potentially oversized position.
On the other hand, immediate emotions are experienced in the moment and influenced by external factors- for example, anger because of a broken laptop, or irritability because of a skipped lunch. These emotions can lead to impulsive decisions unrelated to the trading plan, often posing a substantial risk to a trader’s portfolio. Immediate emotions tend to impact a trader’s decision- making more directly, yet are harder to identify.
Trading generates intense feelings for traders, whether they are winning or losing. Emotions can greatly impact how a trader makes decisions. Problems may arise when certain emotions cause destructive and detrimental trading behavior. It is less important whether the emotion is immediate or anticipated, and instead we should be focusing on identifying the specific emotion and understanding its effect on our trading. Much has been said about fear and greed in trading, but there are other emotions that can have equally negative effects. In this blog, we will look at happiness, fear, anger, sadness and greed.
Happiness
When in a positive mood, traders may inadvertently downplay risks and make impulsive decision. They are more likely to think about their potential gains, and believe they are more likely to happen (this is called the saliency bias). Being in a happy mood also means traders are more likely to perceive ambiguous information (such as a market signal) as a positive sign, and so they’re more optimistic about their risk.
Overconfidence during winning streaks can lead to undisciplined trading, hindering the learning process and impeding progress towards becoming a proficient trader.
The impact of Anger in your trading
Anger has the opposite effect. When angry, traders tend to take big risks, and often blow up their accounts quickly. These high-risk situations can become self-defeating. The more a trader loses, the angrier they are likely to feel (at both themselves and the market). This can lead to even more destructive decisions, such as revenge trading.
The impact of Fear in your trading
Fear has a different impact. It can induce risk aversion, often hindering the proper execution of an effective trading strategy and may lead to missed well-reasoned trades and poor risk management. A rational level of risk aversion should be effectively incorporated into a trader’s risk management plan. However, emotionally driven excessive risk aversion, may cause traders to trade emotionally, making poor decisions and departing from an effective risk management plan, as part of their trading strategy. A trader who is feeling fearful may play it too safe, and close winners earlier than planned, they may fail to close a losing trade, instead avoiding the decision, and leaving the trade open, to potentially turn into a bigger loss. Fear often prevents a trader from executing a well thought out trade strategy.
Fear of losses can cause a trader to stick to the status quo, even when inactivity may not the best option available. Traders who feel fear, whether directly from imagining a loss or from an external force, like watching a horror film, have tendencies towards inertia, this may lead to poor decision making and poor execution.
The impact of Sadness in your trading
By contrast, when feeling sad, traders can tend to be risk-averse, setting lower expectations and potentially missing out on well-reasoned trading opportunities. The inclination to close trades prematurely and depart from a well thought out trading plan can undermine overall trading performance.
The impact of Greed in your trading
Greed is another emotion that can have negative effects on trading decisions. We know about greed contributing to various bubbles. People bought stocks and had quick wins, so traders continued to buy more and more, hoping to replicate more quick wins, thus inflating the value greatly. People can act greedily when the expected reward far exceeds the expected time and cost to be invested. They want easy wins. Trading while feeling greedy can cause a trader to ignore targets, stops, and other parts of their trading plan. Overconfidence caused by this greed can also result in a higher risk of loss.
In summary, the resulting action for each emotion is:
Happiness – underestimate the risks
Fear – we fail to act (inertia)
Anger – Overreact (Revenge)
Sadness-risk averse
Greed – Take bigger risks
How to navigate emotions in trading
All these actions can result in traders not sticking around in trading. We can’t solve this by avoiding
emotions. They’re an unavoidable part of the trading experience. So what can we do?
We recommend a 3-step system: Identify- Pause-Unlearn
Identify
Before each trading session, ask yourself how you are feeling. Then decide how much you are feeling that emotion, from a scale of 1(barely) to 5 (intensely). Referencing tools such as Geneva Emotion Wheel can help you with this.
Pause
When you are experiencing intense emotions, avoid making any major decisions. Hit pause on what you are doing. Take a break and come back to your trading later when you’re more neutral. If you have to trade, reduce your trade size so you are reducing the emotional effect of those trades.
Unlearn
The hardest step is trying to unlearn your instinctive behaviour when emotional. Start by holding yourself accountable. Have a trading plan, and review at the end of every trading day whether you stuck to your plan or not. It is particularly important to be in a stable emotional state when you do your post trade analysis, so that you can give yourself the best chance of a realistic self-assessment.
Conclusion
While emotions are an inevitable aspect of trading, adopting a mindful approach can mitigate their impact. Awareness of your emotions is the first step to take. Following that with structured three-step system (1) Identify, (2) Pause, (3) Unlearn—can empower traders to navigate emotional influences effectively. By understanding the intricate relationship between emotions and risk perception, traders enhance their decision-making skills, fostering a more resilient and strategic trading mindset.
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