How to control emotions while trading
Letting the heart rule the head can make matters worse — and amplify the losses we would have realized if we had taken a rational decision to exit a position much earlier.
Learning how to control emotions while trading is a difficult, but important, lesson for every investor to learn. Letting the heart rule the head can actually make matters worse — and amplify the losses we would have realized if we had taken a rational decision to exit a position much earlier.
Something that many traders don’t realize — even those who have been in the industry for decades — is that their line of work requires tremendous discipline. Aside from accurately predicting the ups and downs that the market may experience, half the battle is knowing when to walk away from an investment.
When it comes to personality traits, trading is often best suited to people who are comfortable making big decisions quickly. Those who dither in a difficult situation, painstakingly weighing up the pros and cons, often miss out because lucrative opportunities have evaporated by the time they’ve made up their mind. Traders who are able to respect the rules — especially ones they have set for themselves — also have a decent chance of mitigating losses when things don’t go to plan.
In this article, we’re going to provide some useful tips on how to manage emotions when trading. Feelings of regret and overconfidence are only human, but being aware of your weaknesses can go a long way to stopping yourself from being your own worst enemy.
Tips to control emotions when trading
1. Know what you’re afraid of — and why
Let’s imagine you own a sizeable proportion of stock in a major company. Things have been going well, with modest dividends, until a huge news story breaks that embroils a senior executive in a significant scandal. When share prices begin to fall, it’s common — even understandable — to start panicking and selling off shares in a heartbeat. However, this is a short-term view that fails to think about the long-term. Before making an investment, it’s worth taking an objective view about how you would react should a worst-case scenario happen. Reflecting on your instincts, and whether such kneejerk reactions would actually be in your best interests, can go a long way to helping you install barriers that make you think twice before making a rash decision.
2. Don’t be greedy
So you’ve managed to invest in a winning stock that has experienced explosive growth in recent months. You’re starting to get complacent — and as a result, you’re holding on to shares even though rational analysis would tell you that prices are likely to begin cooling off in the not-too-distant future. Knowing when to call it a day and to cash out is a highly underrated skill that too few traders have. A determination to squeeze every last drop out of a bull run can be dangerous, as making a gracious exit a little earlier would have preserved profits. By bowing out when things are good, you have the opportunity to pursue other opportunities.
3. Set some rules
This brings us nicely along to our next point. One of the best ways to control emotions when trading is to set some clear parameters surrounding when you’re going to sell shares — irrespective of whether it’s good times or bad. Perhaps you’ll set a cast-iron rule to offload stock when its value rises 20% above what you paid for it, or cut your losses when they fall 7% below your purchasing price. Being stubborn and sticking to these rules can prevent a lot of heartache — and could stop you from making impulsive decisions that result in you losing even more money. Of course, there will be times when your analysis tells you that a steep drop in an asset is temporary, and that things are going to bounce back. Rules are there to be broken, but this should only be a rare occurrence.
4. Be wary of positivity
It’s very unfashionable to speak ill of pessimists. They’re the people who have their glass half-full even when the odds are stacked against them, the people who act like the sun is shining even when the rain is pouring outside. However, when it comes to trading, being too positive can have calamitous consequences financially. It can stop people from exiting positions because they believe that things are going to turn around, and even stop traders from rationally confronting the scale of their losses. The best way of overcoming this is shrugging off confirmation bias and always being open to reading research and vital statistics that suggests things aren’t as rosy as one would hope.
5. Accept losses
This is perhaps the best bit of advice when it comes to controlling emotions when trading: acknowledge that there will be times when you’re on the losing side of a transaction. A star tennis player can’t win every match, an epic poker player can’t outsmart rivals on every hand, and every trade you make won’t realize a substantial profit. Set those rules to sell whenever shares fall below a certain level — and once it has happened, learn the lesson and don’t think any more about it. It’s sad but true that there are some correlations between gambling and trading, given how there can be a temptation to chase losses and enter into bigger and bigger positions.
There are dozens and dozens of biases out there that affect every trader on the planet, no matter how they experienced they are. By opening your eyes to what these vulnerabilities are, you have a better chance of coming out tops.