Emotional Biases

So as humans, the first thing you need to understand is that we are terrible at assessing risks without systems in place to take emotion out of the process, it makes day trading risk management all the more difficult.

As a day trader, you must constantly remove your emotion-based beliefs about risk from the actual statistical probabilities in order to gain a clear picture of what’s happening and avoid many of the common trading pitfalls.

Trading is a fast-paced and high-stress environment that inhibits one’s ability to think critically, often forcing the brain to rely on emotion to make snap decisions.

So let’s look through some of the common emotional biases

Confirmation bias – this is the tendency for day traders to put more weight on third-party research that supports their own beliefs rather than looking at things objectively. By doing so, traders may be basing their decisions on faulty information.

Gambler’s fallacy – This is the belief that past performance influences the current odds of something happening, such as three or four down days in a row, leading to an up day. This belief is actually widespread among traders.

Overconfidence Bias – It’s what it sounds like, this is where day traders overestimate their own abilities relative to the market. If traders are not careful, their overconfidence can lead to problems down the road, such as overtrading, or excessive risk-taking.

Negativity Bias – Here you have traders placing more focus on negative events than positive events. This can lead to unnecessary caution. For example, a trader will be much more conservative after experiencing a big loss.

Let’s talk about some mistakes traders make especially when it comes to trading frustrations:

Trading out of boredom

If they haven’t made a trade that day something is wrong, some traders just can’t sit on their hands for the day and wait for another day. They force a trade that goes against their strategy and rules. They convince themselves a pattern is forming and they jump in only to take losses.

Trading to get back losses

If you are trying to overcompensate for a previous loss or something that happened the day before or the week before, you are trading on emotions. You are asking to lose that way.

Trading with scared money

So when you say you have to make X amount of dollars a day or else, you won’t be thinking clearly if you get in your own way by forcing yourself that you must hit that certain goal.

This is different than having a daily profit goal. 

Just because my goal is to make $200 a day, I know for a fact that I’m not going to make exactly $200 every single day. I may make more, less, or nothing at all if I don’t place any trades, and I am ok with all of those scenarios.

There will be days when I will have a loss, its going to happen, but I’m going to minimize those losses as much as possible and not try and fight the market to make up for it. I’m just going to walk away and live to trade another day.

Believing they’re not down unless they sell

They are holding on to a losing position and in their own mind if they sell, that’s when they think they lost. An unrealized loss is a loss, and remember that it can get worse.

Believing the stock can’t go down anymore

Just when you think a stock can’t go down anymore, a stock at 1 penny can do what is called a reverse split and end up coming back up at a dollar, and then it can keep falling.

Don’t rationalize bad trades. These stocks are vehicles to trade. You trade them and you sell them. You don’t start researching why you should hold a certain position for the wrong reason.

Next: Risk Control »