4 Trading Fears & How to Handle Them - Part 1

08/26/2013 6:00 am EST

Focus: TRADING

All market timers, traders and investors, in every kind of market, feel fear at some level, writes Frank Kollar of Fibtimer.com.

Turn on the news one day and hear that a steep unexpected sell-off is taking place, and most of us will get a queasy feeling in our stomachs. But the key to successful "profitable" market timing, in fact all trading, is in how we prepare ourselves to handle trading fears. How we prepare to deal with the risks inherent in trading.

Mark Douglas, an expert in trading psychology, says this about trading fears in his book Trading in the Zone.

"Most investors believe they know what is going to happen next. This causes traders to put too much weight on the outcome of the current trade, while not assessing their performance as "a probability game" that they are playing over time. This manifests itself in investors getting in too high and too low and causing them to react emotionally, with excessive fear or greed after a series of losses or wins."

As the importance of an individual trade increases in the trader's mind, the fear level tends to increase as well. A trader becomes more hesitant and cautious, seeking to avoid a mistake. The risk of choking under pressure increases as the trader feels the pressure build.

All traders have fear, but winning market timers manage their fear while losing timers (as well as all traders) are controlled by it. When faced with a potentially dangerous situation, the instinctive tendency is to revert to the "fight or flight" response. We can either prepare to do battle against the perceived threat, or we can flee from this danger.

When an investor interprets a state of arousal negatively as fear or stress, performance is likely to be impaired. A trader will tend to "freeze."

There are four major trading fears. We will discuss them here, as well as how to handle them.

Fear of Losing
The fear of losing when making a trade often has several consequences. Fear of loss tends to make a timer hesitant to execute his or her timing strategy. This can often lead to an inability to pull the trigger on new entries as well as on new exits.

As a market timer, you know that you need to be decisive in taking action when your strategy dictates a new entry or exit, so when fear of loss holds you back from taking action, you also lose confidence in your ability to execute your timing strategy. This causes a lack of trust in the strategy or, more importantly, in your own ability to execute future signals.

For example, if you doubt you will actually be able to exit your position when your strategy tells you to get out, then as a self-preservation mechanism you will also choose not to get into a new trade. Thus begins analysis paralysis, where you are merely looking at new trades but not getting the proper reinforcement to pull the trigger. In fact, the reinforcement is negative and actually pulls you away from making a move.

Looking deeper at why a timer cannot pull the trigger, a lack of confidence causes the timer to believe that by not trading, he is moving away from potential pain as opposed to moving toward future gain.

NEXT PAGE: Fear of Missing Out

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No one likes losses, but the reality is, of course, that even the best professionals will lose. The key is that they will lose much less, which allows them to remain in the game both financially and psychologically. The longer you can remain in the trading game with a sound timing strategy, the more likely you will start to experience a better run of trades that will take you out of any temporary trading slumps.

When you're having trouble pulling the trigger, realize that you are worrying too much about results and are not focused on your execution process.

By following a strategy that unemotionally tells you when to enter and exit the market, you can avoid the pitfalls caused by fear.

We learned long ago that unemotional (non-discretionary) timing strategies save us during emotional times in the market. We know the strategies work, so we put aside our fears, and make the trades.

And remember, you must be able to take a loss. Consider them as part of trading. If you cannot, you will not be around for the big gains because you will be on the sidelines guarding your capital against that potential loss.

Remember that good timing strategies are designed to guard against big losses. Every trade you take has the potential to become a loss, so get used to this reality and take every buy and sell signal. That way, when the next big trend starts, you will be onboard and profit from it.

Fear of Missing Out
Every trend always has its doubters. As the trend progresses, skeptics will slowly become converts due to the fear of missing out on profits or the pain of losses in betting against that trend.

The fear of missing out can also be characterized as greed of a sort, for an investor is not acting based on some desire to own the stock or mutual fund-other than the fact that it is going up without him on board.

This fear is often fueled during runaway booms like the technology and Internet bubble of the late-1990s, as investors heard their friends talking about newfound riches. The fear of missing out came into play for those who wanted to experience the same type of euphoria.

When you think about it, this is a very dangerous situation, as at this stage investors tend essentially to say, "Get me in at any price-I must participate in this hot trend!

The effect of the fear of missing out is a blindness to any potential downside risk, as it seems clear to the investor that there can only be gains ahead from such a "promising" and "obviously beneficial" trend. But there's nothing obvious about it.

Remember the stories of the Internet and how it would revolutionize the way business was done. While the Internet has indeed had a significant impact on our lives, the hype and frenzy for these stocks in the 90's ramped up supply of every possible technology stock that could be brought public and created a situation where the incredibly high expectations could not possibly be met in reality.

It is expectation gaps like this that often create serious risks for those who have piled into a trend late, well after it has been widely broadcast in the media to all investors.

Next week read part 2, the conclusion of this article on trading fears.

By Frank Kollar of Fibtimer.com

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