TRADING PSYCHOLOGYStudying Risk Behavior
by Ari Kiev, M.D.
Taking risk and taking losses are two different parts of trading. HereÕs how to manage the emotional side of risk-taking.
If you think about it, the markets are a natural laboratory for studying risk-taking behavior, especially decision-making in a volatile, unpredictable, and uncertain environment. It is the given task of the trader to reduce risk by identifying patterns in sectors, companies in specific as well as the marketplace in general. This can be an extremely difficult task for even the most sophisticated of traders as we have seen in the past year, due to not only the turbulence in Asia and the falloff in Russia and Latin America, but the turmoil in European markets as well.Not only have traders had to deal with the uncertainty and the volatility and illiquidity of the markets, they have had to contend with the psychological consequences of failure and, in many instances, newly discovered vulnerability. They have had to deal with loss.
THE PROBLEM WITH LOSS
The problem with loss is that it can set in motion a variety of responses that could in turn trigger a self-fulfilling negative trading spiral. The emotional trader seeking to recoup his losses may end up exposing himself to riskier trades rather than stem his losses by controlling his downside risks. He may hold on to losing positions far longer than is reasonable in the unfounded hope that his failing positions will rally. In so doing, he risks losing even more of his confidence as well as passing up opportunities to gain by more judicious allocation of his capital.
Far too often when positions reverse, traders may be emotionally whipsawed and choose to seek a quick profit when things improve. They may hesitate to hold on to long winning positions because they are anxious to avoid the trap of falling stocks again. In such occasions, emotion rather than reason may come to govern the upside of their trades.
Continuing loss may also lead to decision paralysis and a reluctance to "pull the trigger." Such problems can best be overcome by reducing the size of trades to manageable levels in a trader's comfort zone until the trader regains his or her confidence. Still others may suffer from burnout and need to take time out until their energy and enthusiasm have been restored.
Excerpted from an article originally published in the June 1999 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1999, Technical Analysis, Inc.