FALLING IN LOVE WITH A TRADE
How Loss Aversion and Regret Impact Trading Performance
How Loss Aversion and Regret Impact Trading Performance
In his book, Blink, Malcome Gladwell describes an event where the experts from the J. Paul Getty Museum in California encouraged the museum's purchase of a marble statue purported to be from the sixth century B.C. The statue was an amazingly rare piece with an estimated value of just under $10 million dollars. There was only one problem. The experts from the Getty museum failed to detect what outside experts had suspected and then later confirmed; the statue was a fake. So why were the Getty museum's experts not able to confirm what outside experts suspected at first glance? Because the Getty museum's curators desperately wanted the statue to be authentic. Such a rare find would have been a tremendous boost to the museum's status and prestige.
Traders can fall into the same trap. When you put on a trade, especially if your trading methodology calls for just a few trades per day, you can fall in love with each trade because you desperately want it to be a winner. Compound that with not wanting to be bored or feel unproductive, not knowing when the next trade will come along, and having your self-worth intrinsically linked to the profit or loss of any given trade, and you have the perfect storm for a trader who falls in love with a trade and ends up holding a loser too long. Too great of an expectation is placed on the trade. Like the museums curators, the trader is so smitten by the trade and the boost they hope it will bring to both their emotional and tangible bottom line that they cannot discern when the trade is no longer valid.
I can vividly remember an occasion when a favorite chart pattern of mine, the Head and Shoulders reversal pattern, manifested so completely picture perfect that I was counting the money from the moment I put on the trade. I had begun to plan a vacation around the profits that this trade was certain to generate. I was absolutely, 100% convinced that after executing my entry, all that was left to do was sit back and wait for the huge profits to roll in. But then the position moved against me. Then it went a little further against me. Then even further. But because I was so convinced by the original chart setup, even though the price action had negated the chart pattern, I did not get out. I continued to move my stop loss away from the market into further negative territory in hopes that the market would eventually turn back around and go in my favor. I was so in love with the trade that it clouded my judgment. By falling in love with the trade, I turned manageable loss into an extreme loss.
Traders don't fall in love only with losing positions. Traders can fall in love with winning trades just as easily to their detriment. Having a winning trade on produces a euphoric condition. There's no getting around this. It feels good to have a winning trade that continues in your favor. Like a good book or a good movie, you don't want it to end and that's where the trouble begins.
As an example, let's assume you are long 4 YM futures contracts (e-mini Dow futures, $5 per tick) at 10,100. The market is now trading at 10,150. You are feeling great! The market reached your first objective of 50 points and you sell 2 contracts. You just locked in $500 dollars profit and you are still long 2 contracts. At the top of your DOM trader you can see that your current long position is worth $500.
Let's further assume that your trading rules call for you to trail your stop on the remaining 2 contracts 25 points below the market. You move your trailing stop up to 10,125 and the market begins to reverse off of its highs of 10,150 and close in on your stop. You see the value of the position diminish. What was once a $500 profit on 2 contracts is now $300 and falling. But because you are so emotionally attached to the $500 profit that once was, you begin to move your stop lower hoping that the market will reverse and go back up above the old high of 10,200. You keep moving your stop lower and lower until it becomes a breakeven or even a loss. What happened? You became so focused and fell in love with what the trade was worth at its height of $500 that anything less than that $500 dollar gain feels like a loss. You get out too late.
You can see this phenomenon unfold every day on the game show Deal or No Deal. Going onto the stage, contestants are hyped up and focused on the highest prize, which in the US version is $1,000,000 dollars. They begin the game with the mindset that anything less than $1,000,000 is a loss.
As the contestant opens briefcases with low numbers, they successfully keep highly valued briefcases in play. As the highly valued briefcases stay in play, the banker's offer begins to steadily rise as well. It's not unusual to see contestants decline offers of $350,000, a figure six or seven times what they make in a single year. That's because if the $1,000,000 dollar briefcase is still unopened, "settling" for $350,000 is perceived as a $650,000 dollar loss and not a $350,000 gain. The concept of Loss Aversion helps to explain this irrational human reasoning.
Loss Aversion
Psychologists Daniel Kahneman and Amos Tversky performed numerous studies in the 70s and 80s that reveal how people manage risk and uncertainty. They called these studies Prospect Theory. In Prospect Theory, Loss Aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Their studies suggest that losses are twice as psychologically powerful as gains. Loss aversion is a powerful force that leads to distorted decision making.
Deal or No Deal contestants continually demonstrate the irrational behavior and distorted decision making produced by Loss Aversion. Because human tendency is to prefer to fend off financial loss (or a perceived financial loss) than to acquire financial gain, almost all Deal or No Deal contestants end up chasing one of two things to their detriment:
1. The highest remaining dollar value on the board or
2. The previously highest banker's offer
Rather than viewing the banker's current offer as a gain, contestants (and the friends and family who cheer them on) irrationally interpret the spread between the banker's current offer and the highest valued briefcase on the board as a loss. (It's also very common to hear the family and friends say things like, "You deserve it!" That's a different topic for discussion). In order to ward off the pain of this "loss", contestants keep opening briefcases, almost always to their peril.
This is a classic case of Loss Aversion. Loss Aversion has established that the pain of loss is more intense than the pleasure of gain. In order to avoid that pain, contestants become irrational in their decision making. This helps to explain why these contestants stay on the podium far too long.
Regret Theory
Regret is an additional dynamic which reinforces and exaggerates the irrational behavior of loss aversion.
If the contestant declares "Deal", they know that the show's host will ask them to open the remaining briefcases in the sequence that they would have chosen had they not taken for the banker's offer. As each briefcase is opened, the deal that would have been offered is plastered in big and bold numbers across the top of the display board for all to see. The contestant is fully aware that they will be asked to go through this exercise, which impacts their ability to accept any offer from the banker. The contestant knows before making the deal that they will have to endure the regret of seeing what they could have made had they stayed in the game. Any offer that comes in above the Deal amount causes the contestant to experience regret. Each subsequently higher forgone offer is perceived by the contestant as a loss and carries with it many times the pain than the pleasure of the Deal's gain. The intense desire to avoid regret also helps to keep contestants on the podium far too long.
Traders are subject to the same irrational decision making influenced by loss aversion and regret. When a trade moves into positive territory, a trader is presented with higher and higher "offers" from the market. At any point in time, they can proclaim, "Deal" and lock in profits. But doing so can feel like quitting the game while the highest valued briefcase (the trade's ultimate profit target) is still on the board. Or, if the trade has backed off from its previously highest profitable level, getting out below that level can feel like accepting an offer lower than the banker's previously higher offer. And if they get out, they know that they will have to endure the regret of watching the market continue to meet or exceed their original profit objective. The market will continue to open briefcases and reveal what the trade would have been worth had the trader not declared "Deal" and gotten out of the trade.
Protect yourself from yourself
No matter how many books you read or recordings you listen to, it is virtually impossible to not experience regret as a trader. You will most certainly have trades that continue in your originally anticipated direction after you've gotten out. It's going to happen and it's going to happen often. The best thing that you can do is accept this fact and then protect yourself from the irrational decision making that loss aversion and regret can produce. And the best way to do that is by using non-negotiable stop-loss orders to protect your downside risk and trailing stops to protect your gains.
A trailing stop works as a "Deal" mechanism to protect you from the irrational behavior of loss aversion when you have profit in a trade. A trailing stop cannot keep you from experiencing the pain of what you perceive as a loss, even though it is actually a profit. Nor can it keep you from the regret you may feel as the market continues to "open briefcases" after you've gotten out of your position, allowing you to see just how much more money you could have made. What a trailing stop will do is protect your profits and allow your trading business to grow. A trailing stop will enforce the boundaries of healthy trading behavior. A trailing stop will keep you from experiencing the negative impact that regret, loss aversion and falling in love with a trade can have on your trade management behavior.
Multiple contract strategy
In order to maximize your trading profits, you have to trade multiple contracts (I'm speaking of commodity futures trading here). A good strategy to maximize the potential of any trade is to liquidate portions of the position at profit target points and keep a portion of the position in play in hopes of reaching the ultimate profit target. As each subsequent profit target is met, a portion of the position is liquidated to lock in profits. The remainder of the position, "the runner", is protected with a trailing stop that is placed at breakeven or higher to keep a winner from turning into a loser. Until the trade really begins to move in your favor, I think it's best to have your trailing stop no further than where the first profit target was and not at break even. But the market conditions and the trading rules you develop will help to define those parameters for you.
As the market continues to move in your direction and closes in on the ultimate profit target, continue to move your trailing stop in tighter and tighter. If your trailing stop is hit and then the market moves on to the ultimate profit target, so what! At that point you maximized the trade and locked in some really nice profits.
Successful traders know that they will almost always have to give back some of what the winning trade was worth at its highs. In Deal or No Deal terms, when successful traders play the game right and take reasonable risk, they know they will probability not walk away with the highest banker's offer, but it will be close. They won't chase it back down to the lows. And, successful traders know that not all trades reach their third and forth profit target. Again, using the Deal or No Deal analogy, their goal is not necessarily to walk away with the million dollar briefcase, but to strategically maximize the banker's offer. When you understand this as a trader and utilize the tools at your disposal, like trailing stops, you protect yourself from the irrational behavior that loss aversion and regret can manifest.
So, do we have a deal?
Bill Provenzano can be contacted at Upside Breakout
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