Pitfalls Encountered with Emotional Trades

At one time or another, most traders, including myself, have traded by emotion. In coaching sessions and in conversation with many traders over the years, I have seen countless examples of emotional trades and emotional trading. There has been one constant in those observations and it is that those who continue to trade with emotion without some discipline fail. Some of the emails I receive and some of the traders I meet seem to think about buying a stock as they might think about buying a lottery ticket. They go in with a euphoria, or at least excitement that they are going to hit the jackpot. More often than not, they have no exit strategy whatsoever, nor have they considered the risk or the potential reward to risk ratio.

As I set out in my book, "Trade Your Way to Wealth" successful trading involves some self-examination and planning. In the book, I talk about elements to include in the plan and the necessity of having an exit strategy before ever entering a position. Adherence to a simple plan designed for you can really give you a chance to become a better, more successful trader. In the following material, see if you see yourself in any of the examples and then ask yourself how did it work out? A coaching client told me that his failures came from "the little man behind the curtain." He pointed to the back of his head indicating that the "little man" was that voice we have in our heads.

A while ago, I was talking to a guy who told me he bought a stock because he "knew it would go up." Another fellow told me he was buying a stock because he thought it would go up. Neither went up. Each of those traders suffered real losses. What did they do wrong? They approached the trades in "Pollyanna" fashion, "knowing" or believing that the stock would move in a specific direction and ignoring a decision on where they would get out if they happened to be wrong on the direction. Why would they ignore the possibility that their stock would go down? My guess is there were two reasons: first, a case of mild euphoria about the big gain they would get (greed) and second, refusal to recognize, or at least sublimating, an unpleasant emotion -- loss. If we look at things rationally, wouldn't we agree that there is literally no stock that couldn't go down? (If there is, please let me know as soon as possible). Recognizing that any stock can fall in price not matter what we think it will do might lead us to agree that an exit strategy in the event we may be wrong on the direction makes sense. At a rational moment, we can decide exactly where we will cut our loss. If we fail to make that decision ahead of time, aren't we leaving things to our emotions and aren't we more likely to listen to that little voice in our head that says: "it'll come back" even as we go deeper and deeper into the red?

Another example of emotional trading I have seen is the person who grabs a profit as soon as there is one to grab. I've heard a trader say, I took the profit right away because I was afraid I'd lose it. After his exit, the stock moved another $30. The fear caused him to cut his profits and miss another $30 a share. His exit strategy was "the little voice" probably saying something like "Get out of this position, remember the last time you had a profit and you let it turn into a big loss. Don't do that again." Yank, the plug gets pulled. Would a more disciplined approach yield a better result? My guess is in more cases than not, it would. The idea is to cut losses, not profits and to let profits, not losses, run. A predetermined exit strategy such as a trailing stop as I discuss in the book, can keep you in the game through little retracements and market chatter while limiting losses in the event of a reversal. You can create your plan and then execute it so that you simply follow a pre-determined exit strategy. Does that mean you still won't have losses? No. Does it mean that you will always let profits run throughout their whole move? No. It means you are likely to improve your trading by limiting losses and giving yourself a better chance to avoid cutting profits early.

Trading is not about hitting the lottery. It is about having the gains add up to more than the losses. Successful trading involves giving yourself a little edge. The "hot reactors" of trading do not give themselves that edge. They tend to bet it all on black and though they might hit every so often, they are not giving themselves any edge. They are truly the gamblers while the pro traders make themselves the house.

Bottom line is it is your money and your risk so you are entitled to do it however you want. I prefer trying to get an edge, but I really appreciate the hot reactors; they make life a little easier for me.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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The Anger Amazes Me, But Proves the Point

Last weekend I wrote a little article suggesting that perception, not necessarily actuality, moves the markets. In the article I quoted -- yes, quoted, not made up or voiced my opinion -- some positive facts about the economy taken from front page articles in Investors Business Daily. At first I was stunned by some of the responses which, among other things suggested that I was "smokin crack," was an elitist who "hung out with the likes of [the President], and that my head might be "screwed on backwards" if I didn't agree with the emailer's opinions. It really makes me wonder whether these people ever learned civility and manners. I have no problem with disagreements and readily confess that I am not always right. I am, however, ashamed for those who use name calling as a way to attempt to bully others into sharing their opinions. Name calling generally seems to be an emotional approach when someone disagrees but has no reasoned basis or facts to martial in support of their position. Name calling is nothing but divisive and has no power of persuasion, nor does it make any positive contribution to a dialog.

My bottom line in last weekend's article which was directed to trading was: "...if we can gauge the perception of traders, their current psychological bent, we are more likely to be able to give ourselves an edge in our trading. In general, and in the short to mid-term, it is the psychological, not necessarily the logical, that moves markets." Another way to say it is that the markets move on emotion at least in the short term.

Well, emotion is what I saw in some of the responses. One critic even chose humiliating sexual names for the President and Vice President of the United States. No matter what your political persuasion, I believe the Office of the President deserves to be treated with respect and dignity. How in the world referring to a President of the United States as slang for female genitalia moves the ball forward is beyond me from any reasoned perspective. However, these statements are clear and unequivocal examples of emotional responses triggered by that person's perception. It isn't logical, it isn't reasoned, and it isn't a fact. It is a response founded in emotion arising from a mistaken belief that I was trying to take a political stance. The attackers' positions spewed from a perception that I disagreed with their political values. I don't smoke crack, am not an elitist friend of "the likes of [the President]," and can see my face and chest at the same time in the mirror so it is probably not screwed on backward. Those are facts, but they are the direct opposite of the perception upon which the name-callers based their writings. They emoted based upon perception, and made no apparent effort to confirm that their perceptions were based on any facts.

The emotional responses in the Blog are rarely accompanied by supporting fact. They usually seem to be shouts of opinion. The same is true of emotional trading. Traders operating on emotion buy because they "like" a company and hold a stock when the price is falling because "it'll come back." I've heard more than one trader say he is hanging onto a particular falling stock because "it has been good to me." That doesn't seem to be a particularly clever way to cut losses, for example, but it is a way people's perceptions (right or wrong) control their trading. Because they may have made money in a stock before becomes the standard. "It has been good to me before." The truth is that my opinion is essentially irrelevant as to what a stock price will do. Because I think a stock will go up doesn't make it so. As a successful trader, I need something other than emotion to trigger my entries and my exits.

That is my point about the markets. They, like our name-calling friends, tend to overreact emotionally to their perceptions. It is precisely that human phenomenon of emotional reaction to market entries and exits that often results in losses for those traders. The traders who can achieve discipline and awareness of "mob" psychology are the ones who are more likely to have gained the edge and succeed.

The hot reactors are fodder for the market professionals. Trade like the emotional name-calling writers write and the pro will get their money every time. Ready, fire, aim is the emotional approach. It is fine and natural to be aware of and perhaps even defensive about one's perceptions, but, in trading, the thoughtful approach may work a lot better. By that, I mean that I would suggest a trader examine the fundamentals of a stock to be generally aware of what and how the company is doing and, in important addition, look at the reward to risk potential, and then set a specific entry and exit strategy before entering a position. Stopping the process when we perceive that it is a good company and our opinion is the stock will go up will probably not save the day. As you can see with an approach like that, our emotions may play a part but they do not control the trade.

One personal opinion that I want to share is that I believe humanity has a better chance with civility. Often the other guy, no matter what his political affiliation, has good ideas too. If we reject someone's ideas simply because they are from a different political party (or other difference), it is we who are likely to be the fool.

Emotional decision making strikes me as something similar to an angry bull charging a man with a sword; it may be what anger prompts him to do, but it isn't very smart.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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Perceptions

Suppose you were watching the TV news last week and learned:

- Personal income jumped 1.9% last month
- Disposable income was up 5.7%, the sharpest gain in 33 years
- In the last 20 years, the average lifespan has increased by 3 full years
- As a nation we have never been healthier
- Real pre-tax income per worker hit an all-time record and was up 11% since the current president took office
- Americans net worth is $15.3 trillion more than it was seven years ago
- Since 2000 nonfarm business productivity has expanded 21%
- 9.2 million jobs have been created since 2001
- 80% of poor households have air conditioning and 97% own color TV sets

Those facts certainly would paint a pretty rosy picture, certainly nothing like the economy we have really been hearing about on the news. No wonder the markets have made it to official bear territory and no wonder the indexes saw one of the very worst June's. What a different world it would be if those were the facts. While this setting may be a far cry from today's reality, it would be interesting to see how those factors might influence market direction.

Oh wait, according to two articles on the front page of Investors Business Daily on Monday, June 30, 2008, respectively entitled "Do Foreboding Headlines Reflect Real Trends or Media Mind-Set?" by Terry Jones and "Rebates Fuel Spending, But Consumer Outlook Tough" by Scott Stoddard, those are the true facts. The list above represents selected facts that help describe current conditions, but though quite positive, are having little apparent effect on market conditions and movement.

The answer, at least in part, is people's perception as opposed to actuality. In listening to the news on network TV and in reading various publications, the perception seems to be that the sky is falling. Clearly, oil prices are heading out of sight and many of the financial institutions are in trouble as a result of their relationship to the sub-prime mortgage crisis, and many people may lose homes for the same reasons. As far as most of the network news I watch goes, that's the whole story. The perception is that things are in terrible shape.

As is often the case, the markets at least in the shorter term react or overreact with emotion to perceptions. Here, I would suggest, the perception is that the economy is in the tank, almost doomed; the outlook is bleak. The reality, I would suggest, is not quite so bad as the perception. Just look at the positive facts listed above, and things seem a little more balanced at least. I don't mean that high oil prices are good for our economy nor do I think that the sub-prime crisis shouldn't have a significant affect, I only mean to say that on the whole things are better than they are portrayed day to day. If the perception (whether right or wrong) is that things are bad then market action is not only likely to be bearish, it is likely to be more bearish than the facts actually warrant.

All this is to say that if we can gauge the perception of traders, their current psychological bent, we are more likely to be able to give ourselves an edge in our trading. In general, and in the short to mid-term, it is the psychological, not necessarily the logical, that moves markets. The psychological reactions in the market are, in many cases, driven by perception rather than reality.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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How Many Positions to Hold

Last weekend, in response to a subscriber's question, I discussed the issue of how much money a trader needs in a trading account. As is often the case with trading, the answer is "it depends" on the individual and his or her goals, needs, risk tolerance, time available to trade, and so on. That same subscriber had also asked how many positions to hold in order to have a good mix of issues. Again, the answer is completely dependent upon the individual.

One of the most important, if not the most important, factors to examine in answering how many positions a trader should have is how many can that individual manage. I often have as many as 30 positions working at one time, but I certainly would not recommend that high a number for the vast majority of traders. Trading is what I do, so I am devoting a significant amount of my time to monitoring, entering, exiting, and adjusting positions. Clearly, that is a much different scenario from someone who can only look at the markets on the weekend or at night. I once had a student who traded for a living and only had one position at a time. I have lost contact with her, but the last I had heard, she was a successful trader.

Many factors influence how many positions a trader can manage at one time. They include the trader's level of knowledge, the strategies he is employing, and the time he can devote to his trading. Obviously, in terms of monitoring, it is one thing to buy a stock and place a trailing stop and quite another to trade near the money naked puts which might require relatively quick action to adjust, close, or roll the position. In Appendix D of my book, "Trade Your Way to Wealth", I set out 15 strategies and compare things like the level of monitoring required for each as well as things like relative risk, capital required, time frame, desired market direction, and expected time frame.

Depending upon capital, a true buy and hold investor who has a full time job could hold a fairly large number of positions while that same person who pursued a different strategy like swing trading long options would probably hold a smaller number of positions. As I have written in the past, these are considerations the individual investor should address when creating his individual personal business plan. The conclusions may well differ for each trader, but it is an important decision. Trying to manage too many positions can result in missing something on one or another -- believe me, I speak from experience. In my early years of trading, I was so excited about what I was doing that I did make the mistake of having more positions than I could effectively track and I burned myself. That episode taught me to limit the positions to a number I can manage and I have been faithful to the concept ever since.

In the coaching sessions, I sometimes encounter students who have not considered a limitation on the number of positions and find it difficult to keep up with themselves. I try to suggest that they establish a comfort zone both in terms of risk and in terms of manageability. It is my personal belief that traders should confine themselves to strategies and amounts of risk that permit them to sleep comfortably at night. Inability to manage positions whether it be from lack of knowledge, lack of experience, or just too many positions to manage does not lead to relaxed trading in my estimation and that, in turn, can lead to emotional and bad trading decisions that we all want to avoid.

I hope you are enjoying a wonderful 4th of July weekend!

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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