Reality check – fear not greed is traders’ biggest problem
01:00, 24 december 2015
· Av CMC Markets
By Ric Spooner, Chief Market Strategist, CMC Markets Australia
With the holiday period being a good time to think about improving your trading next year I thought some ideas on trader psychology might be of interest to readers
Recent weeks have seen plenty of volatility as markets became alternatively worried or unfazed about the Fed’s impending rate hike. Buying the rumour and selling the fact of the ECB’s stimulus decision and big changes in commodity prices added to market volatility.
For many investors, these situations are just short term noise to be looked through. For others, market gyrations can be a source of both joy and fear. How you see these moves can depend on whether you are an investor or a trader.
Many people are both investors and traders. Where that’s the case, results will usually benefit from being quite clear about which activity you are engaged with any particular transaction. As a rule it’s best to operate trading and investment activities quite separately. They involve overlapping but quite different skill sets and strategies.
Key among these differences is that successful traders have a very different attitude to the fear of loss than most. That’s not to say they are cavalier about risk, far from it. Sensible risk management is essential to trading success. Good traders know they have to be extremely disciplined. Otherwise the best they can hope for is to luck out for a time while things are running their way.
Paradoxically, it’s fear of loss that makes a lot of people abandon risk management.
To demonstrate, ask yourself how you would answer the following questions:
You have $10000 and you must pick one of the following choices:
A 50% chance of winning $10000 and a 50% chance of winning nothing OR
A 100% chance of winning $5000
You have $20000 and you must pick one of the following choices
A 50% chance of losing $10000 and a 50% chance of losing nothing OR
A 100% chance of losing $5000
The trader’s answer is to select A in both cases if you are risk taker or B if you are risk averse. Both A and B have the same probability of success. However, A is riskier because it’s the double or nothing alternative. Research shows that most people will chose B for question 1 but A for question 2. They are risk averse with profits but willng to take more risk in order to avoid losing.
Naturally people tend to approach trading from the perspective of making money. In reality many of their trading decisions are motivated by the fear of loss. This is especially the case with decisions about when to quit a trade. Responding to the fear of loss stands us in good stead when it comes to many of life’s decisions. However, with trading it’s often what brings people undone. It’s why a lot of otherwise successful people struggle to succeed as traders.
The classic example is the strong desire to abandon trading risk management rule 101 by holding on to losing positions until they eventually come good. Even worse are unplanned decisions to double up and average down as prices move against a position. A lot of the time, these strategies will work. The problem is that every now and again they will come spectacularly unstuck. Big losses result, making it pretty much impossible to succeed as a trader over time.
Traders is about making money by having the value of your winning trades exceeding the value of your losing trades over a given period, say a year. This is analogous to a retailer’s sales revenue exceeding its cost of goods sold. In just the same way that retailers can’t make money if they don’t buy inventory, traders can’t make money if they don’t have losses. While most people understand the logic of this, it seems that basic psychological drivers stop a lot of people acting on it. When it comes down to it, they will constantly chop and change their strategy in an attempt to avoid every single loss.
Fear of losing is not the only psychological driver that traders need to conquer. One of the best books on trading psychology is Mark Douglas’ Trading in the Zone. He identifies 4 primary trading fears that I’m sure most of us are familiar with:
Leaving money on the table
Recognizing the problems these primal drivers create and overcoming them to develop a winning attitude to markets is crucial to success. It’s significantly more important than deep market knowledge or analytical ability.
As Mark Douglas says, good traders respect markets but they aren’t afraid. They have the mental flexibility to go with the flow and adapt to what markets are telling them but they don’t throw their strategies out the window and act on either reckless euphoria or fear.