What is emotional trading? It is the feelings that you have when you are trading. These feelings tend to be one of the biggest hurdles that traders have to overcome to make money. They all have their own issues that they are looking at when trading in the market. It is the sum of all of these people that make the market. So how to do you take advantage of this information.
You do this by taking the complex and trying to simplify it. There are two basic emotions that are the overriding driver behind emotional trading. They are greed and fear. There are a number of combinations of these two emotions but for now we will mainly focus on these two and how to spot them.
This chart explains emotional trading in a nutshell. Click on the chart for a printable version. After review the chart continue on reading about the levels of greed and fear.
Think about how you feel when you are trading. How do you look at the market? What are the emotions you feel when you trade? For most people the reason they trade the market is to make money! This seems to be a no-brainer….. right! Well not really. There is a lot of other emotional reasons people trade the market. One of the main reasons outside of making money is to prove that they are RIGHT! This is an incredibly hard emotion to overcome. The other destructive reasons to trade the market are to subconsciously sabotage themselves, which gets into being a victim. This gives them the support for why everybody is out to get them and how they aren’t responsible for what has happened. There are a lot of possible types of emotional trading problems that traders bring to the markets.
Greed one of the seven deadly sins!
Let’s start with greed. This is probably the worst of the two emotions behind emotional trading. Greed is a very interesting emotion. It can grab you when things are good and it can grab you when things are bad. You lose your common sense over greed. When it comes to trading, greed tends to be an emotion that worries about missing an opportunity. You don’t want to have watched or screened a stock only to watch it go up without you. In emotional trading greed will try to tell that someone else is making money and you are not. Greed doesn’t just make you think about these things it gets in your gut and makes you feel these things.
So how do you spot greed in the markets? How do you use this emotional trading effect to give you an edge as a trader? It is not as easy as it sounds because there are so many different personalities trading the market. Some traders are taking systematic traders and others are more discretionary. So greed can be hard to spot. I think the first thing you can do to gain an edge is to monitor HOW GREED AFFECTS YOU! If you have a better understanding of what triggers your greed then you can overcome the bad trades that it causes you to take.
The second way to take advantage of greed is to look for consensus indicators to give a broad market view of what is going on. For example, look at mutual fund flows. Are investors jumping into equities, bonds, or commodities and look for reason why. This could be a result of emotional trading on a large scale or what most people call “herd mentality”. Remember consensus indicators are contrarian indicators and change stay extended either way for a long time. Use these types of indicators, such as Bullish Consensus Number, Mutual Fund Flows, Put Call Ratios, and Bears versus Bulls as an additional tool in your trading.
Greed Level One – you just entered a position and it is working: This is easy! I don’t know why everybody thinks trading is hard.
Greed Level Two – things couldn’t get much better: This is so great! I think I should buy more, before it doubles. I don’t need to worry about my position size and risk if it always goes up!
Greed Level Three – I am a genius: Maybe I should start my own hedge fund and manage other people’s money. I think I could make over 150% this year if I keep it up. That new house is just a few trades away.
Greed Level Four – did I sign the margin agreement: It is time to buy more. Margin only cost me 6% a year and this position goes up about 6% a week. It is okay if this position is now more than 60% of my account because nobody ever got rich being diversified. Why did I every listen to those experienced traders, they must not know what they are talking about.
Fear the next cycle!
Fear is the second way that most traders get derailed. Fear in my opinion is not quite as bad a greed. The reason is fear typically only surfaces when things are going against you. Fear is easier to spot than greed which is another reason it is not as bad. So what does fear look like? In emotional trading there are several levels of fear. As you read think about how fear affects you. There are many additional level of fear when it comes to emotional trading. These are the main levels of fear that most traders faces.
Fear Level One – you just entered a position for the third time ON MARGIN and it moves against you: Why didn’t I wait to get in? It will stop pretty soon, this position always goes up. This level does not concern you very much but you are a little fearful that you may have made a mistake by buying into the position for the third time.
Fear Level Two – the stock keeps going against you: Should I go ahead and sell the position? As soon as I sell it, it will go back up. Let’s watch it and see if it finds some support here. At this point you are somewhat upset and it is an uncomfortable feeling of not knowing what to do. You threw position sizing out the window, so you do not know how much risk you are taking. You start having actual physical reactions to the loss.
Fear Level Three – the stock gaps down: Oh crap!!!!!!!!!!!!!!!!!!!! I knew I should have sold the position. It is definitely too far away from my entry price to exit now. It will stop going down if I don’t watch it. I don’t even want to see what it is doing. Where am I at on my margin? At this point your head is not controlling your actions. Your physical emotions are taking over. As you think about the position your heart beats faster, you feel your ears getting warm, your palms are sweating, and you can’t think straight.
Fear Level Four – relief rally: See I knew it!!! Here we go time to get back some of my money. I will exit my position as soon as I get back to even. At this point you are emotionally tide to this position. It is not a trade anymore it is a game of who is going to be right, you or the market. NOT A GOOD GAME TO PLAY!!
Fear Level Five – failed to rally and is moving against you even more: I am only going to wait for a little longer to see if we get a recovery. There must be something going on with this position that I don’t know about. Where is the SEC, are they looking into this stock? At this point, you have to take a mental break because this has got you completely exhausted. You are very worried about margin calls.
Fear Level Six - the position keeps going against you: MARGIN CALLS!!!!!!! I’ve had enough. I am getting out of the position and staying out. At least I got out without have to borrow money from my family to pay back the margin.
So how do you use this example to help you gain an edge in trading? First and foremost, don’t ever get into this position! Always have a predetermined exit point prior to entering a trade! One of the biggest reasons for getting all the way to Fear Level Five is you did not have an exit plan prior to entering the position. Also, you must be disciplined in using your predefined exit points. You must exit when your stop is hit. This is another way Greed will come into play. You will have stayed disciplined with every one of your last 10 stops only to see the stock immediately reverse. So greed starts telling you to wait and see what happens after it hits your stop and then you are in the Fear Trap!
Another way to use this to gain an edge is to watch the market for signs of fear and be patient. This is where greed comes back into play. You spot fear in the market and you start to get excited that this may be a good entry point. Just don’t forget that fear can and usually does get worse. Most traders can spot fear between Fear Level Two and Fear Level Three. It is very possible even probable that you will get to Fear Level Five, so be patient and control that GREED!
Remember working on your emotional trading is just as if not more important to your trading than the system itself. Visit Trading Psychology to get more information about how to work on your emotional trading.