Trading Psychology – Dealing with Loss Aversion
When it comes to trading psychology, in order to be successful in the markets traders must master loss aversion.
Loss aversion is being unable to accept a loss once in a trade. You tell yourself you’ll get out if you lose a certain amount, but just before getting stopped out you decide to hold onto the trade and let the loss grow. It is an unwillingness to accept and realize a loss; instead the trade is held, in hope that it will swing back in your direction.
Problems Created by Loss Aversion
Loss aversion causes you to deviate from your trading plan. Based on your method, you know that you will win about 60% of the time, just as an example, and that your method produces a certain amount of profitability after each week or month of trading (accounting for winners and losers). The problem is, by not adhering to risk management rules. and letting a trading loss grow, losses become bigger than originally calculated. Those additional losses, even one each week, can turn a profitable system into an unprofitable one.
With leverage, one loss which is allowed to keep running can clean out a whole account.
The bottom line is that you should be trading with a plan that has some sort of positive track record. None of us likes to lose, but by succumbing to loss aversion our plan is thrown out the window. The trading method is no longer calculated and results will likely be poor or inconsistent at best.
Trading Psychology – Causes of Loss Aversion
We fear loss because your brains do not assign the same weight to a $100 loss as it does to $100 gain. The happiness at finding $100 on the street doesn’t equate to the frustration of opening your wallet and realizing you lost $100 you needed to pay for something. Think of it this way, not having a relationship with someone isn’t as painful as having someone and then losing them. Our brain typically assigns 2.5 times the weight to a loss, as it does to a gain (Kahneman and Tversky, 1979).
We don’t like to lose, and statistics show the majority of humans will gamble in order to avoid a loss. In the 1979 study, participants were asked if they preferred a $7500 loss, or they could “roll the dice” for a 75% chance of losing $10,000 or a 25% loss of $0. Most opted to gamble. In trading terms this is like moving your stop-loss. You can take your loss, or let it mount. If you let it mount there is a possibility you may get back to even, but there is a good chance you’ll end up losing more because you’ve already be proven wrong on the trade.
The real problem is that if you get back to “even” after gambling in this way, your behavior is rewarded. You did the wrong the thing (you went against your trading plan and your stop loss rules) and it worked out. But most of the time it won’t. It’s a trap, and it lures in new traders and casino gamblers alike.
Trading Psychology – Managing Loss Aversion
The unfortunate part is that there is no easy fix for loss aversion. Losing sucks; as humans we don’t like it and it results in a steady stream of trading problems. The good news is that there is a solution…it’s just not easy.
Where the issue stems from doesn’t matter, ultimately you need to conquer it. That doesn’t mean you won’t want to avoid losses, it just means you accept those feels and don’t let those feelings affect your actions. It is within your control. Think about other areas of your life where you feel strong emotion, but don’t act on it. Instead you remain present, compose yourself and act according to your plan or principles.
Therefore, the first step in managing loss aversion is to have a plan in the first place. If you get into a trade and don’t know how you will handle it if it moves in your favor, against you, or does nothing, then you shouldn’t be in the trade at all. Your plan of attack let’s you know what you will do in each scenario. It also let’s you know which trades to take and which to avoid (See: Forex Trading Strategies Guide for Day and Swing Traders ).
That plan must provide details on how you will enter and exit positions, and then you must follow that plan no matter what sort of emotions you face while in those trades. Know there will be a strong compulsion to let a loss mount because you don’t want to realize/book the actual loss, due to ego or some other reason. You will feel these things. Admit it, and
try to continually bring yourself back to your trading plan, letting the plan play out. Do this in a demo account until you are like a robot at following your plan. Only then should you switch to real money–start out trading with the smallest position size possible so it is easier to maintain your robotic focus. Expect emotions to crop up again once you begin trading with real money.
If you have adequately tested your system, and it is profitable, then realize that the results of that system account for losing trades. You don’t need to avoid them–the losses are already factored into the profitability, so you don’t need to change a thing. Take your loss when you are supposed to; stick to the script. That’s the only way to realize the profitability of your system.
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It easier said than done though. Therefore, I recommend all new traders, or any trader who is having trouble sticking to their trading plan, put out a stop loss order and a target at the outset of each trade. Then don’t touch anything. Watch, and simply sit on your hands. Don’t touch your orders, don’t touch your screen, just sit on your hands until either your target or stop gets hit.
Follow this method for at least several months. It will get you used to the feeling of discomfort, and most of all it will prove to you that your system is profitable just as it is, without your intervention (assuming it is actually a profitable system to begin with). Even if it isn’t profitable the exercise is a good one for discipline. Trading is mostly psychological–being able to overcome these trading psychology hurdles.
Not succumbing to emotional moments, and seeing a plan through is what creates great traders, great leaders. great generals, etc.
Many traders will find that letting the price just hit their stop or target, with no intervention, is fantastic, and the journey ends there. Others will want to more actively mange positions. Only after months, or hundreds of trades, of letting price hit the stop or target hit should you attempt to actively manage trades. Don’t skip steps, otherwise the same issues will continue to ail you. Practice discipline and following your plan by letting the price hit your stop or target, that is it. Only when that discipline is firmly entrenched should you consider more elaborate strategies or attempting to mange each trade according to a plan.
If, after developing your discipline, you decide to actively mange each trade still set a stop and target. The stop can never be expanded, but the stop can be reduced if the price moves in your favor. The target can be expanded or contracted, based on current conditions, but the expected reward should always be greater than the risk (stop) at the outset of the trade.
Loss Aversion – Final Word
Loss aversion manifests itself as an unwillingness to take a loss. When this occurs the plan for the trade has been tossed out, and therefore, trading results are likely to be unprofitable or inconsistent at best. As humans we put more weight on losses than gains, so the problem won’t just go away. You need to deal with it, face it and practice dealing with these emotions in real time. Just reading/knowing about it isn’t enough. The best way to build discipline and deal with feelings of loss aversion is to trade a strategy for several months (or hundreds of trades) letting the price hit a stop or target set at the time the trade is opened. Sit on your hands, and learn to deal with the emotions, knowing that your risk is controlled, your target is set and your plan is in motion.
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