It is a fact that when an investor is under stress, whether from fear or euphoria, their emotions can take precedence over reason. It’s important to approach investing with reason and common sense, even in situations when the market changes drastically. This may be hard to do, particularly when you are losing money.
Emotional trading is a habit you need to cut if you’re ever going to become a successful trader. If you’re new to trading or have found yourself trading emotionally a few times, then having a strong understanding of emotional trading and what it entails will benefit you. In this article, I will outline what emotional trading is and how to avoid it.
What is emotional trading?
Emotional trading is when a trader makes trading decisions based on their feelings rather than carefully analyzing the market and making informed decisions.
This could be either positive or negative emotions. For instance, due to the hype of a particular stock on social media, an investor decides to buy the stock out of excitement, without carefully analyzing the stock. An investor might also sell their stocks immediately after the market begins to crash for fear of losing money or sell as soon as the stock goes up out of greed. These are all examples of emotional trading and may lead investors to significant losses.
Situations where you might be tempted into emotional trading
On a normal day, you might be able to avoid emotional trading, but there are situations when you are tempted to ignore all rationality and do as your gut tells you. When you can recognize these situations you might be able to better prepare yourself and act accordingly when they occur.
- Bear and Bull Markets: Bull markets are times when prices rise continuously and sometimes indiscriminately. While bear market is the opposite, where financial markets trend downward for many months or even years.
During periods of market fervor and widespread investor euphoria, investors may see investment possibilities or hear about investments from others, including friends, family, coworkers, or the media, which may encourage them to go into uncharted territory. The investor may get so excited that they attempt to profit from new investments that are arising as a result of optimistic market circumstances.
Similarly, investors may sell their stocks out of fear when they read about a weak economy or hear about a turbulent or unfavorable market time. - After a loss: Investors are most vulnerable immediately after a loss. It’s inevitable to feel sad or angry when you lose but you should never allow those emotions to cause you to make rash decisions.
This might then lead to revenge trading out of anger and greed or an aversion to reentering the market out of fear. - After a win: Everyone wants to profit when they make investments and it’s never seen as a bad thing when it happens.
However, the giddiness that comes with winning might lead to overconfidence and pride, causing you to make rash decisions. - Timing the market: Investing emotionally is often a practice of poor timing of the market. Keeping an eye on the media may help you identify whether bull or bear markets are developing since daily stock market news reflects everyday activity, which sometimes generates excitement among investors. But news stories may sometimes be based on hearsay and be out of date, flimsy, or even illogical.
Since individual investors are ultimately responsible for their own trading choices, they should exercise caution when attempting to time market chances by following the most recent news.
The secret to assessing intriguing prospects and avoiding poor investment ideas is to use practical and logical thinking to determine if an investment may be in a development cycle. Reacting to the most recent breaking news is often an indication that emotions, not logic, are guiding your actions.
How to avoid emotional trading
Controlling the behavioral urges of emotional buying and selling that arise from tracking the ups and downs of the market is equally crucial for investors. Follow the following advice if you don’t want to fall into the trap of emotional trading.
1. Determine the characteristics of your personality
Early identification of personality is important for establishing good trading psychology. You must be honest with yourself about whether you are impulsive or more likely to act out of irritation or rage.
If so, you should be mindful of these characteristics when you trade actively as they may induce you to make snap judgments with little support from analysis. But it’s also critical to capitalize on your unique advantages. For example, if you are a calm, calculating person by nature, you might benefit from these qualities when trading.
2. Create and adhere to a trading strategy
The key to making sure you reach your objectives is to have a trading strategy. A trading strategy serves as the framework for your trading and should include information on your time commitments, available trading capital, risk-reward profile, and preferred trading approach.
Outlining the rules for initiating and closing a trade may assist you in minimizing losses and reducing the impact of emotions on your trading.
Trading strategies should also include personal aspects like emotions, biases, and personality qualities that may have an impact on your trading discipline. You may be less likely to act on your prejudices if you are upfront about them before you begin trading.
3. Be patient
Reacting to negative emotions such as fear may cause you to exit a trade too soon, costing you money. Have faith in your analysis, and practice patience and self-control.
Likewise, it’s crucial to exercise patience and wait for the appropriate opportunity before making a deal rather than jumping into one right away.
4. After a defeat, take a rest
Sometimes, instead of jumping into another trade to make up some of your losses, the best course of action after a loss is to take a little break from your trading account to collect your thoughts and organize yourself.
The most successful traders are those who accept their losses and turn them into teaching moments. Before returning to their platform, they usually spend a few minutes to themselves. During this time, they analyze what went wrong with that specific transaction in the hopes of avoiding the same error in the future.
By allowing oneself to cool down before approaching the next deal with a clear brain and solid judgment, one can control emotions such as pride or fear.
5. Take your prizes
Remaining calm after a defeat is crucial, but so is quitting while you’re ahead and collecting your gains. A string of victories or one especially significant victory might give you the impression that you are unbeatable, leading you to strive to repeat the success in another position.
Since today is “your day” in the markets, you can even initiate a string of fresh positions with the hope that none of them will fail. This can lead you to diversify your portfolio too soon or take unwarranted risks without thoroughly researching each market.
When it comes to trading, happiness can be just as harmful as rage. As such, it’s critical to recognize when happiness may be influencing your decisions or negatively affecting your trading mentality.
Conclusion
Fear and greed are powerful motivators for many emotional and reactive investors. Fear and greed are often strong motivators when it comes to people and money.
Rationality may be greatly aided by having a clear understanding of both your own risk tolerance and the dangers associated with your assets. It’s also critical to have an active grasp of the markets and the factors influencing bullish and bearish movements.
Overall, research indicates that adhering to a well-defined investment plan and persevering through market volatility often yields the highest long-term performance returns, even if aggressive and emotional investing may sometimes be lucrative.
