Trading Psychology – Dealing with Loss Aversion
One important aspect of trading psychology is dealing with losses. It is not more important than proper dealing with winnings, as winnings might lead to euphoria and can produce or upgrade greed, but for this article, the focus is on dealing with losses; or more closely described – mastering loss aversion.
Mastering loss aversion means getting into a state where a trader can relieve of the fear of loss. Sometimes, a trader can’t cope with thinking about losing, and losing is really a part of trading, so no confusion should arise there that a successful trader never loses.
The major problem with loss aversion happens when a trader decides to get out of the trade after a certain amount lost, but just after that happens, the trader decides to try to go more with the same trade and thus just multiply the loss. The trader does it because he or she believes that they can avoid losing. So instead of getting out, the trade continues in hope to get back to the winning side.
Loss aversion makes traders leave their scheduled plan. For example, a trader’s strategy tells him or her that in the next month, winnings are going to happen in sixty percent of trade. But, in a trade the trader starts thinking that a particular step can be skipped (which is in the particular example a losing – but calculated – step), which can bring an additional percentage. And when the entire losing trade ends with more account cleared than originally calculated, that means that the 40 percent losses are still 40 per cent of total losses, but the overall amount lost is now greater. Obviously, in this example, one such mistake doesn’t have to mean total loss, but should it be repeated, it can turn a 60 percent into less than 50. And with leverage included, such a loss can wipe out entire account.
This problem amounts especially if this mistake was due to psychological weakness; then it can happen again, and that is a serious problem.
Causes of loss aversion
Fear of loss occupies a trader more than euphoria of gaining does. An example to this is the happiness for finding a “Benjamin” on the street, and the fury after realizing that you lost one from your wallet. Or think about losing something, or never having it at the first place. It is actually a scientific fact that our brain gives more space for losses, than it does for wins.
Studies showed that people prefer gambling for a 75% chance to lose $100, and 25% chance to keep it all, rather than losing 75 sure, and keeping sure $25. In trading, it is gambling your stop loss. In fact, the option to gamble in this example occurs only if there is an inevitable loss approaching.
But, if the trader calculates well, and takes into account a certain number of losses, well that’s what stop loss is for. There is no need to gamble to lose more. And since the stop-loss situation has been activated, that means that the trader had counted on it to happen, which also means that the situation the trader is in is the one that he or she doesn’t believe to turn for better. And the belief is based upon calculations and planning. So, why should anybody change mind now, in the middle of the loss? When the stop-loss activates, it means the things have gone downhill. And that is something that’s “been planned”.
The greater problem occurs when sometimes this way a trader gets back out of the loss and thinks that it is possible to trade this way. But fortunately, these things don’t happen often, because if those things happened, nobody would ever invent stop-losses. Going against strategy has been proven wrong anyway. It’s statistics, not an assumption.
Managing loss aversion
When a trader goes into loss aversion, it is hard to get out of it, as it is from any psychological trap. But, regardless of avoiding fear, greed, panic or euphoria, nobody likes losing, and that’s what makes it harder. We’ve seen how it happens; let’s see now how to overcome it. Is it possible for somebody who can’t accept losses to somehow become a person who accepts losses as a part of job?
It is again all about leaving emotions behind, or aside. It is important to prepare and arm with knowledge. That implies knowing that for trading successfully, a plan is needed. And to have a plan, knowledge is needed. Again – to trade successfully – a plan is needed.
When a trader has a plan it doesn’t mean that loss aversion will simply fade. As in the example, loss aversion occurs even when things go by plan. Definitely, a loss has to be a part of a plan, and no strategy can be made that disregards losses. So the question is how to avoid falling into loss aversion even when you have the plan? If a trader doesn’t have a plan, that isn’t really a serious trader, and there are more important issues to overcome first.
It is important to truly believe in your plan. That is the key to overcome emotions that might rise during the trade. When you are 100% sure that your plan is going to work, only then you can say “no” to your emotional suggestions that imply you changing your plan in the midst of the way. So, it is essential to believe in your plan 100%. Now, it is possible that you made certain mistakes and your plan didn’t work out. Then the key is to revise your steps and analyze how the plan was not the best one.
This means, in order to manage loss aversion, make sure to analyze your steps that brought you to lose your 100% well planed trade.
It might sound harsh to be sure in your plan, and it might sound as I you should practice before you enter the trade. Well, it does mean that. A trader has to practice first. It is possible to practice with a demo account, and by practicing the platform, the market, the ongoings; you can practice your patience as well. Make a plan, stick to it and carry it through. Surely, on a demo account, you won’t feel need to “save” your money with a wrong move. When you build up your power of will, it might turn out helpful when you turn to trading with real money. Just remember that a stop loss is something you planned and that the planning took place before the trade, when you were not under the pressure. When the trade is happening, you are under the pressure and your thinking isn’t clear. Keep that in mind that when you planned, you were smarter than you are when the trade is happening.
You will see this to be true after the trade, anyway.
Planning well and following through. So, when executing a trade, prepare stop losses, prepare targets and just sit back and practice for a year, for months. If your strategy is good, you will see that managing loss aversion this way helps to go through your trade to the end. If the strategy wasn’t good from the beginning, you will be able to detect the mistakes. But if you interfere with your trades, you won’t be able to detect the rights and wrongs.
Not falling to emotions and seeing a plan through is what creates great traders, great generals, great leaders…
Letting the price hit the stop or target is something you will have to get used to before you are prepared to interfere with the trade. As said before, months of time before being able to interfere – after analyzing what happens, then you can move things a bit yourself, but in this case, not because of fear, but because of caution and knowledge.
Still, in order to avoid falling into this psychological trap, even when you think you know your way, don’t forget to set a stop and a target.
Loss aversion takes place when the trader is not willing to take a loss. When this happens, he or she interferes with the plan and the outcome usually ends not in their favor. That is because it never went there. It is the fact that humans find it more difficult to cope with losing, than they are more euphoric with winnings. It is important to practice the moves that are related to psychological thinking and “planning”. It is not good to interfere with plans. It not just destroys something we thought is good, but we also lose the opportunity to see if we were right, and we can’t use that particular trade to be an example for future trades.
The best way to practice this is to trade a strategy for a long time and let the price hit the targets and stops, without interfering with it (if possible on a demo account – that way we can literally sit on our hands and watch the trade go by in accordance with our plan) and learn to handle the emotions, assure that risk is controlled, targets set and plan in its motion.