Case Study: How Emotion affect Trading

Trading is Buying and selling securities or commodities on a short-term basis, hoping to make quick profits.You might hear of rags to riches stories or traders boasting about the money they made in a trade. Its am exciting business but the fact is only 5% of traders are able to make money on a consistent basis.

If you have ever interacted with  Successful traders he would say  that psychology and emotions are 80% of the battle.

Do not overestimate your ability to be unaffected by emotion.

Real Life vs. the Trading Terminal

Have you ever imagined why doctors,engineers, and maths graduate who are quiet strong in analytical skills  have burnt hands in trading ?

The pressure and stress you’ll face will be far greater than anything you’ve ever experienced.

When I first started trading, I was confident of my math and analytical skills – so I thought I could base all my trading decisions purely on analysis, unaffected by emotion.

Nothing could be further from the truth – to see why, let’s walk through the emotions of a trade.

Trading Highs and Lows

To simplify the matter lets illustrate the trading emotion using an Intraday Trades,similar emotions can occur over Swing trades and positional trades ranging for weeks or even months.

9:15 AM: You watch as the market opens. You are looking for a good buy entry point into LUPIN based on your analysis you think that LUPIN has given a breakout above 1838 and you are waiting for the confirmation signal during market hours to take the trade.

10:30 AM: LUPIN inches upward till 1844  for an hour from you entry price ie.1838,you are waiting for pullback near your buying point to take trade.LUPIN then takes a small dip. You think, “Great chance to buy on the dip!”  Originally you were planning to buy 1000 shares, 500 for intra-day trading and 500  for positional trading.

1000 shares? That means even if you successfully catch a 20 stock price move, you only make a measly 20K? Better double that.

You buy 2000 shares of LUPIN at 1838 (Emotion: greed), contrary to your initial plan and risk guidelines. Based on your technical analysis, you plan to take profits on half of your shares at 1858 and cut losses at 1828.

12:30 PM: Nifty zooms upward after European Market opens up. LUPIN zooms upwards along with the Nifty. 1844. 1850.. 1858.. you’ve reached your profit-taking point!

But wait! You don’t take profits yet (Emotion: greed) The rally isn’t over. 1860. 1864. 1870.. sweet! This is awesome! (Emotion: elation) You’re not sure why it’s going up this far, but who cares?

You’re making money. You pat yourself on the back. Maybe you’ll buy yourself an expensive lunch to celebrate.

1:15 PM: LUPIN rally starts to weaken.. then it starts to move sideways.  C’mon, this rally has got to have another leg up, right? (Emotion: hope)

Then LUPIN starts to fall slowly… 1865 1858… Well, that doesn’t mean the rally is over, right?

Your technical indicators tell you a falling trend has began, but your heart tells you that this could be just a slightly oversized downward correction and that the rally hasn’t ended yet (Emotion: denial).

1:45 PM: LUPIN starts to trend down further. 1854.. 1848 You want to bash your head against your keyboard. Why didn’t you sell earlier? Why is this dropping so much anyway?

Some FII or  hedge fund must be short-selling huge amounts to manipulate the price. It’s not fair that hedge funds are bigger than I am. (Emotions: anger, frustration).Price starts falling on rapid scale 1838 (Cost Price).1832 and 1828 🙁 you’ve hit your stop loss point but you fail to hit the sell button. After all, LUPIN was having a great day. Surely the price will bounce back up eventually? (Emotion: hope)

2:00 PM: 1823… 1815…1810  the selling spree is not relenting. You minimize the window that shows your losses because it is too painful to watch. Why didn’t you sell earlier?

You’ve just erased everything you’ve made from weeks of trading. How are you going to ever make this money back? (Emotion: despair)

You stop caring about how much LUPIN can drops (Emotion: resignation). It’s already a huge loss anyway… what’s a couple more thousand matter anyway?

2:30 PM: 1800… your technical analysis indicators show that right now may be a good buy entry point.

You know that you already have 2000 shares and you can’t afford to take any more risk. But you are mad at LUPIN and you want to get revenge.

You call your broker ask for extra leverage after few if and buts he aggress and you get more leverage. You double down and buy another 2000 shares, bringing your total share count to 4000 (Emotion: desperation).

2:45 PM: LUPIN starts to nosedive. Wait, what!? LUPIN dropped 10 rs in 1 min? 1790…1765 What is going on? What are you going to do? (Emotions: panic, fear)

You cringe as you submit a market order to sell all of your 4000 shares at 1768. Almost immediately after you sell, LUPIN stops nosediving and recovers slightly.

You sold your shares at the worst possible price; if you weren’t so panicked, you could have divided your order into chunks and used limit orders and achieved better price execution. You want to cry. You are a failure. (Emotion: depression)

3:00 PM: You spend the rest of the trading day wallowing in misery without making trades. Next day LUPIN opens with a big gap up due to bullish sentiment of global market and it comes back to 1838 and makes a high of 1870 next day.

You stare in disbelief… but there is nothing you can do now – if only you had followed your initial plan… (Emotions: helplessness, regret).

If You Could Do It All Over…

What would an experienced trader have done in the above situation?

Actually, even experienced traders are affected by emotion – I’ve seen a white-haired trader at a bulge bracket investment bank turning red, swearing his head off, and pounding at his keyboard – but I’ve also met a trader in his early 30′s who never once lost his cool.

So the question should be, “What should this trader have done in the ideal scenario?”

In this example, the trader should have followed his own plan and rules strictly – he should have stayed within his risk limits and do not be excessive leveraged, sold the stock when the price hit the pre-determined stop-loss level, and he should have taken his profits when the stock reached the pre-determined profit-taking level.

In short, he should have sold immediately when the stock hit 1858 – yes, that’s “only” a profit of 40000 INR, but it’s way better than losing INR 2.4 Lakh as this trader did.

Experienced traders know when to break their own rules because they have the discipline to not break the rules too often and to keep the risk-taking from getting out of hand.

Traders without such discipline such stick to strictly to their rules to protect themselves. As the saying goes, “plan your trades, and trade your plan.”