How many times have we felt this urge to book our profits when the trade is in profit? The remarkable patience that all of us show when our position is in loss just to square it off once it reaches the break-even point is truly satirical. All the experienced traders reading this article would agree with me that the above behavior is a sure shot way to blow up the trading capital.
I have been trading for last six months and everyday feels like a new day with new opportunities and new things to learn from the markets. I discovered in this six months of trading that I am quite sensitive towards losses and feel like a pro trader whenever I make profits. Clearly, this shows that my behavior and attitude changes whenever I make profits or losses.
This week, I saw a documentary on “How do traders make their decisions“. This served as a perfect documentary for me to find out the root cause of my irrational decisions during trading and behavioral changes based on the outcomes of my trades. Here are some of the experiments shown in the documentary that changed my perspective towards trading.
The Bonus Fallacy
The experimenter asked the volunteers to manage a portfolio in a stock market simulator. The prices of the stocks in the simulator had a reference value and it changed based on the volunteers’ trades.
In the first trading session, they were just asked to make money. The results were simple and the prices of the stocks did not change much from their reference values.
In the second trading session, they were told that the top 3 volunteers who make most money will get a bonus. However, this time the stock prices changed at exorbitant rates. There was a huge surge in prices of the stocks before eventually falling down to its reference values. The results showed the formation of a stock market bubble in a simulation.
The reward of getting a bonus led all volunteers to trade furiously, eventually leading to a heavy loss to most of them. A simple change led the brain take decisions that normally a trader would not have taken.
To bet or not to bet
In this experiment, a group of volunteers were asked a question. Do try answering this in your mind before reading further.
I chose the first option like many of you might have chosen because clearly a 100% chance of winning something is better than 50% chance of winning nothing. This was like taking a risk averse trade. Now the experimenter twisted this question a bit.
What do you think? A 50% chance of losing $200 looks like a good option to bet on, right? Yeah, I too chose the same and found out how my mind made a very risky trade without my brain even noticing it.
When it came to profits, we all are comfortable taking risk averse trades. But, when we are sure of making a loss, we increased the risk of our trade in order to avoid the chance of a loss. We become ready to lose more to have the chance to lose less.
Almost all discretionary trading decisions are based on our feelings, emotions and psychological state. I don’t mean to say that discretionary trading is bad, just that I believe it takes years of experience and practice to become a good discretionary trader who can handle emotions well.
To get over this emotional drawback of discretionary trading, I believe system trading is the best to rely on where a trader religiously follows a system, never questions it during the drawdown periods and compounds the profits as and when they come.
It is not that system traders do not face these psychological challenges, but it does help a trader maintain his sanity to take rational decisions.
That’s it for today.