The 4 Most Dangerous Emotions for Traders

05/12/2014 6:00 am EST

Focus: STRATEGIES

Deron Wagner

Founder and Head Portfolio Manager, Morpheus Trading Group

Ignoring the psychology of trading will almost guarantee your failure in learning how to be a consistently profitable online trader, says veteran trader, Deron Wagner of Morpheus Trading Group.

Mastering the psychology of trading is one of the most difficult, yet underappreciated, elements of learning how to trade stocks, regardless of whether one is trading part-time from home or trading professionally for a living. While there are many books, websites, and resources discussing stock market trading strategies, very little has been written specifically about the psychology of trading, particularly for active short-term traders.

This could be due to the fact that most technical traders, such as day traders and swing traders, tend to be more mathematically oriented, and therefore less interested in "soft" subjects such as psychology. Yet, to ignore the psychology of trading will almost guarantee your failure in learning how to be a consistently profitable online trader. The only time stock traders and investors turn for help on this topic is after they have blown up their brokerage accounts and have finally hit rock bottom. However, in this article, I will improve your trading education by explaining the key psychological emotions to be aware of, and how to avoid the common pitfalls that investors and stock traders commonly experience while learning to trade.

Many stock trading sites recommend that new swing traders “paper trade” to gain experience by practicing in a simulated account. While this may be beneficial for learning to spot technical patterns and entry points, it is impossible to simulate the psychological side of a trade unless you are actually putting your own hard-earned money at risk. In order to master the psychology of trading, a short-term trader must work his way through hundreds of trades in order to identify his personal psychological strengths and weaknesses.

The "Individual" Versus the "Group": Trader Psychology
As a stock market trader or investor, one is constantly fighting a battle between need to think independently and avoiding the urge to fight market momentum (the "herd" mentality). Frequently, an actual stock pick idea can be correct, yet the trade ends up losing money because the investor (the "individual") believes so strongly in the merits of the trade that he fights the powerful momentum of the stock market (the "group"). This typically occurs when an investor or stock trader has the correct idea to buy or sell a stock, but the overall market timing was wrong.

Stock markets only shift momentum from one direction to the other when the "group" decides, NOT when the individual trader believes the reversal should occur. The famous economist and speculator John Maynard Keynes once said, "The market can remain irrational longer than you can remain solvent." Oh, how true this is, in the streets are littered with traders and investors who thought otherwise.

As a momentum trader of any market, the technical trend is always your friend. Fighting against it will only result in losses over the long-term.

Four Psychological States of Emotion: Greed, Fear, Hope, and Regret
There are four psychological states of emotions that drive most individual decision making in any market in the world. They are greed, fear, hope, and regret.

Since the stock market is made up of individual human beings who tend to act in similar manners, a group is formed. It is only the group's opinion that matters during a trend, but it is the individual trader's job to identify the subtle clues as to when a market is about to shift direction.

The clues are there, but they are subtle. An awareness and detailed understanding of these emotions is what keeps the astute technical trader out of trouble by providing a means to identify individual weaknesses. We shall now take a closer look at these emotions, and provide examples of how they influence a trader's ability to consistently make money.

NEXT PAGE: What Are Fear & Greed?

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What is Greed?
Greed is commonly defined as an excessive desire for money and wealth.

In trading terminology, it can specifically be defined as the desire for a trade to provide an immediate and unrealistic amount of profit. When greed sets in, all a trader can focus on is how much money they have made and how much more they could make by staying in the trade. However, there is a major fallacy with this type of reasoning. A profit is not realized until a position is closed. Until then, the swing trader only has a POTENTIAL profit (aka. "paper profit"). Greed also frequently leads to ignoring sound risk management practices.

What is Fear?
According to our poll results, "fear" is the emotion that traders and investors struggle with more than the other three discussed in this article.

Fear is defined as a distressing emotion that is caused by a feeling of impending danger, which results in a survival response. This holds true regardless of whether the threat is real or imagined.

Fear is probably the most powerful of all human emotions. When traders become afraid, they will sell a position regardless of the price. Fear leads to panic, and panic leads to poor decision making. Fear is a survival response.

People have been known to jump off of buildings during market panics. By contrast, no one has ever jumped off of a building because of greed. It took the Dow Jones Industrial Average from 1983 until 2007 (24 years) to rally from 1,000 to 14,200, but it only took two years to lose half of its value (2007-2009). That's a dramatic example of the power of fear.

Fear is a good emotion if it gets you out of a bad trade. If, for example, a stock pick hits its predetermined stop price and the disciplined swing trader exits the trade, then the fear of losing an excessive amount of money protects the stock trader from financial ruin. However, fear can work against a trader when they don't enter a quality setup because they have had a series of losing trades. Just because a trader has lost money in the previous trades does not mean he should be fearful of entering the next trade. That's why we have trading plans. Trading systems are intended to take the emotions out of trading. If you're afraid to enter a quality setup, there's no point in even trading.

When the market is in a state of panic or fear, the swing trader should never try to rationalize or come up with excuses why they should not get out of their positions. During times of fear and panic, it is best to go to cash. Listening to the news, the government, stock experts, or other trader's opinions is a waste of time. If the market (aka. "the group") is in a state of panic, it is best to not fight the trend. The group will always win. You don't have enough money to hold the market up by yourself. It's pretty simple…when institutional traders (banks, mutual funds, and hedge funds) decide to dump their positions, the market will fall (and vice versa). When there is fear, steer clear! When in doubt, get out! Truly understanding the power of fear is one of the key pieces of the puzzle to improving your online trading education.

NEXT PAGE: The Roller Coaster of Emotions for Stock Traders

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What is Hope?
Hope is a feeling of expectation and desire for a certain thing to happen. It's an individual's desire to want or wish for a desired event to happen.

Hope may be the most dangerous of all human emotions when it comes to trading. Hope is what keeps a trader in a losing trade after it has hit the stop. Greed and hope are what often prevent a trader from taking profits on a winning trade. When a stock is going up, traders will often remain in the trade in the "hope" of recouping past losses. Every swing trader hopes that a losing trade will somehow become a winning trade, but stock markets are not a charity. This type of thinking is dangerous because the group (stock market) could not care less about what you hope for, or what is in your best interest. Rest assured, when your thinking slips into hope mode, the market will punish you by taking your money.

What is Regret?
Regret is defined as a feeling of sadness or disappointment over something that has happened or been done, especially when it involves a loss or a missed opportunity.

The negative implications of this emotion are obvious. It is only natural for a stock trader to regret taking on a losing trade or missing a winning trade. But what is important as a trader is not to hyper focus on losing trades or missed opportunities. If you lose money on a trade, then you should simply evaluate what went wrong and move forward. Other than the lessons that can be gained from evaluating each trade, there is no point to spending further time regretting the decision to enter the trade. It is also human nature to feel regret when an opportunity is missed. If you miss a winning trade, then you must move on to the next potential trading opportunity.

When technical traders allow regret to rule their thinking, they tend to "chase trades" in the hopes of still being able to make money on the position by entering it well above the trigger price. The problem with this thinking is that the reward/risk of the trade no longer meets the parameters of good trade management. For instance, by entering a trade 1 point higher than the trigger, the potential reward may be 1 point, but the potential loss may also be 1 point. This sets the reward/risk ratio at 1 to 1. Recall that we prefer trades to have at least a 2 to 1 reward/risk ratio. However, if the trade had been entered at the appropriate trigger price, the reward/risk ratio would have been 2 to 1. Successful and profitable online traders learn to discipline their mind to eliminate regretful thinking.

The Roller Coaster of Emotions for Stock Traders

chart
Click to Enlarge

This diagram does a very good job of summarizing all of the emotions I have discussed in this article, each of which are the driving factors behind the price movement of every market in the world.

Summary: How to Improve Your Stock Trading Education
As humans, it is normal to experience these four powerful psychological elements when trading or investing in the stock market. However, being aware that these emotions are always right on your doorstep is the first step to being disciplined enough to overcome them. When you do, you will find the results of your stock trading operations dramatically improve.

By Deron Wagner, Founder and Head Trader, Morpheus Trading Group

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