Many of us who have been around and trading for a while will remember former Fed Chairman Alan Greenspan's warning about irrational exuberance back in the time of the tech bubble. His warning proved to be prophetic in those circumstances, and I would suggest that irrational exuberance is something against which all traders should guard.

In "Trade Your Way to Wealth" and in my private one-on-one coaching sessions, I regularly urge traders to have a plan and to include in that plan an element focused upon when they will make their trading decisions. My suggestion is that trading decisions be made out of the heat of battle at a time of calm when trading emotions are not running high. I believe we make much better trades when we are somewhat removed from the exuberance attendant to trading during an active market.

I remember working with a student new to trading several years ago. I had gone to his home and we were looking at his broker's internet trading site. I suggested he fill in the blanks to place a mock order to get a little practice working the mechanics involved with a trade. This fellow was a serious type A personality and constantly had his hand on the mouse and kept left-clicking as he moved the cursor around the screen. The market was live and as we proceeded through the exercise, I literally had to grab his hand to stop him from excitedly clicking himself into a trade. While the situation was humorous, it emphasized to me how exciting trading can be and how dangerous that excitement can be.

While the fellow in the anecdote was almost a caricature, I have since see many who become so excited that their judgment is not completely intact. The possibilities are very exciting when we trade, but we need to make sure that the excitement is tempered by reason otherwise we may forget that any trade we make has a risk (sometimes significant) as well as a possible reward.

My suggestion to reduce the dangers of trading by excitement is to make the decisions when the market is closed. If, for example, we see a stock we really like and believe is undervalued but whose price is bumping against a resistance why not place a stop order to buy below a limit IF the stock breaks above the resistance? Using that buy stop limit order, we could set ourselves up to enter a play automatically when the stock actually showed a strong bullish move rather than getting excited and buying it during a live market as it approached (but before it broke through) resistance.

Incidentally, we could also have our buy stop trigger a stop loss at the same time we enter the position if our broker accepts OTO or one triggers an other order. Now we could place all the orders we need at a time of calm.

If you want to test yourself sometime to see how a live market can affect you, try paper trading a 2 minute or a 5 minute chart and pay attention to how your emotions react to price movement even without real money on the line.

The other side of the same coin, of course, is fear. It can result in us pulling the plug irrationally or keeping us in a position we should exit because we are afraid to take a loss. Rational? Probably not, but it happens over and over again, particularly when we make our decisions when the battle is underway. It is best to train before the battle, have the battle plan in place, and execute the plan than to go running into battle with no training and no plan. Irrationally exuberant trading falls in the latter category and, in my view, at least, is best avoided.

Good Trading!
Bill Kraft

January 24, 2009

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