Over time everyone gets humbled by the stock market. Sometimes you’ll get on a roll and you’ll have many trade wins which if you are not careful, can lead to arrogance.
Overconfidence has led to many traders’ downfall. In Chapter 1 of this guide I talked about different biases and overconfidence is one of them. You’ve got to keep your biases in check, you’ve got to objectively look at your performance over time so that way you can eliminate your emotions from the process.
Let me ask you a question.
What’s the most important part of day trading?
Shocker… it’s not making money.
There will be times when you might be tempted to bend the rules in certain situations where you think you will be able to be more profitable.
Maybe you stay in a trade a little longer that’s moving against you, even though you have a specific stop loss in place, you get tempted to remove it as the stock price approaches, thinking it’s going to bounce back.
The next thing you know for no apparent reason, the stock keeps moving lower, then emotion comes into play you think, “Just a little longer and it will turn around,” and the next thing you know you are facing a much steeper loss. I’ve been there and it’s not pretty, nor is it worth it.
Stick to your rules. Do not bend the rules.
Denial – traders love to overuse it and you know what, it just becomes destructive. You will experience losses as a day trader, now it’s not the same as being in a long-term mutual fund, opening up your account, and being down $50 – $100 on the day because it was a bad day in the market, why? It’s a long-term investment, it has much less effect.
Day trading is more impactful on your livelihood at the moment.
So the good news is that there are strategies that you can implement to avoid these problems. We’ve already talked about several risk control methods, stop losses, do extensive testing, don’t use margin/leverage, and keep a record of all your trades.
So what happens when we start emotional trading?
Just think about the emotional impact of money in general. What’s the number one cause of divorce? Fights and disagreements about money, it doesn’t even matter what the household income is, studies still have shown that is the number one reason.
Listen let me explain an important point. If you are day trading, you need to be transparent with your family about your financial situation. If you’re married, nothing burns more than a really bad loss that you have to tell your spouse, but maintaining a lie about it is basically denial.
You’ve heard of dopamine right? It’s a chemical that acts as a neurotransmitter, and these days what pharmacology tells us is that its effect on the brain appears to mediate desire and motivation.
These dopamine pathways in the brain play a major role in reward-motivated behavior.
If you don’t know there have also been studies done in the gaming industry, where gamblers are constantly handing over money in small amounts over time, for a large payoff that more often, if not most often than not doesn’t even result in a large payoff.
It’s about that compulsive engagement in natural rewards, that’s why a lot of the time, people associate day trading with gambling because most people, like gambling, continue to lose money, instead of trying to get an education and learn, they’d rather focus on how quick they can get rich and think they can do it with little effort.
So what is the point of all that?
As a day trader, you face the same emotions, you’ve got to face the possibility of becoming arrogant. If in denial, don’t fall prey to taking risky trades to make up for large losses. Again follow the rules, stay in the market, you give yourself the opportunity each day to make a profit.
Think of it this way, the market is driven by the total aggregate of the emotion of everyone that is involved, its crowd psychology. Sometimes you have to recognize the emotion of the market.
For example, say a company reports a product recall, what do you think will happen to that stock when that news hits, it might drop, a minor little selloff, but stop for a moment.
What does that recall have to do with their revenue or their profit?
The impact is likely to be a lot smaller. What’s going to happen when the collective market realizes the stock’s price is now undervalued? It’s probably going to recover. That works to your advantage, you can profit from that.
So when you place a day trade sometimes you feel like nothing is more exciting, you can literally feel the dopamine levels increase and the adrenaline rise, you’ve got significant money on the line, and you want the pattern you saw, the strategy you used, everything that told you to make this trade, to prove out.
But all of a sudden that trade moves lower immediately. This has happened to me on several occasions. You end up selling right away to try to avoid a loss, sometimes this can lead to overtrading and loss of confidence.
The reverse is true as well.
You buy a stock it goes right up you sell for a profit, you don’t want to start thinking you can never make a wrong call, and the answer to making more money is as simple as trading more.
You’ll overtrade and the odds will start working against you and eventually, you’ll make a questionable trade and lose the profits you gained.
Now yet another psychological experience we face as day traders is the tendency to avoid actually trading altogether, we can get hesitant about it because of a bad experience.
What’s going to happen?
You miss opportunities.
I know I am repeating myself, but the more you hear this the better chance it has of sticking. If you follow your trading rules, you can overcome becoming detached. Follow the process, not necessarily the profit, and don’t analyze so much that you are constantly changing your rules.
Now I don’t know about you but I do not like placing a lot of trades each day. A lot of people believe day traders are trading 20 – 30 times a day on average, some do, a lot don’t.
Personally, it’s not necessary for me to place more than 1-2 trades a day. I’m waiting on my setups, according to my set of rules and strategy, so I know when I enter a trade my expectations are a profit target that’s going to hit my daily goal in that one trade.
You don’t need to try and capitalize on every single opportunity, you’ve got to focus on the risk-reward ratio also referred to as the profit/loss ratio.
Another thing is if you are in a winning trade, you’ve got to exit, don’t deviate from your rules, if you’re sitting in a position where all you have to do is close and you’ve more than made your daily target, take it.
Make sure your exit strategy is clear, you don’t want to watch that stock drop lower along with your profits, because it can turn quick, so when you are up, lock it in.
So if there is one line that you’ll hear going around that I can leave you with its plan the trade and trade the plan. When you first start out, whether it’s your first month, six months, or first year, you might be discouraged if the best you did was break even, it might suck if you lost money too.
You’ve got to have a strong support system in place.
It’s a learning curve, your brain needs to go through that experience to become profitable consistently. No one is going to just give you the answer, you’ve got to gain the experience over time.
Stay focused, stay positive, and keep learning.
Next: Dealing With Losses »