Trading | June 11, 2021

Breaking Bad Trade Behaviors

It can be difficult to keep our emotions from upending our decision-making—especially when we have money on the line. The problem is particularly acute for stock traders, who can often find themselves in emotionally charged situations with considerable sums at stake.

Here’s how to take a clear-headed, more-considered approach to four potentially fraught trading situations.

1. You’re holding on to a loser

Research has shown that losing money is roughly twice as painful, emotionally speaking, as gaining it is pleasurable—a psychological effect known as loss aversion.

The fix: A common trading maxim applies here—cut your losses short and let your winners run. The best way to do so is to create an exit strategy before you place a trade, such as setting a stop-limit order to automatically sell if the stock drops to or beyond the limit price—say, 5% or 10% below what you paid. (Note there is no guarantee that a stop-limit order, once triggered, will result in an order execution.)

Making this kind of upfront commitment can help remove your emotions from the selling process. 

For positions you already hold, ask yourself: Would you buy the stock at its current price if you didn’t already own it? If the answer is no, it’s probably time to sell.

2. You’ve had a string of losses

Losing streaks can happen to the best of us, but sometimes a bout of bad luck can actually be a problem with our trading strategy. Attributing successes to our own skills but failures to uncontrollable outside forces is known as self-attribution bias.

The fix: To begin, make sure you know whether you’re losing or making money on a net basis, then look for patterns in your wins and losses. For example, if your winning trades employ fundamental analysis and your losing trades are based on technicals, you might want to focus more on fundamentals for a while.

As you work to figure out what needs fixing, there’s no harm in reducing the size of your trades. Once your results get back on track, you can increase your risk-taking.

3. The market is tanking

Few scenarios trigger hasty or irrational decisions quite like a massive market decline. As panic sets in, greed, loss aversion, and wishful thinking can all collide. Instead of performing our usual due diligence, we allow price alone to dictate our trade decisions, believing it’s an opportunity for quick and easy gains. At the same time, we may double down on losing positions in the hope that the market will rebound quickly—and our trades along with it.

The fix: First, don’t overlook the possibility that the downtrend could continue. Rather than getting into a trade while the market is falling, consider waiting for a few consecutive positive days before opening a new position. And be sure to do your usual homework on any stock you’re considering—bargain-basement prices alone aren’t reason enough to buy a stock.

4. The market is soaring

Biases don’t just rear their heads when we’re under stress—strong bull markets, too, can trigger a host of suboptimal responses, including overconfidence, self-attribution, and herd mentality. In such cases, many traders let positions stay open too long, even when they’ve surpassed their profit targets. Some even cash out long-term positions to free up more funds to trade, potentially exposing themselves to unwanted risk.

The fix: Above all, remember that gains aren’t gains until you’ve sold the position at a profit, so don’t let a trade stay open too long.

Also keep an eye out for red flags that might lead to a reversal. It can be tempting to take on more risk when prices are rising, but doing so can leave you overexposed if an unexpected correction occurs.

And finally, be sure you’re not risking too much of your investment capital in your trading portfolio. Many traders like to set a limit, such as not taking positions that represent more than 20% of their overall taxable portfolio.

Wait and deescalate

The point here is not to become a robot but rather to be on the lookout for those times when emotions can get the best of us.

If you have trouble distancing your emotions from your trading decisions, it’s never a bad idea to slow down or even take a break. Cooler heads usually prevail, and trading is no exception.