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Trading with Your Head, Not Your Heart: A Handy Checklist

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February 5, 2013
Trade with your head

Emotion is good for marriage proposals and Oscar speeches, not trading. Here’s how to create a gut-check checklist. And actually use it.

Once upon a time a man entered a small, bullish options position in a familiar tech stock. He did everything right according to his trading standards. But as macro-economic problems swelled, and the broader stock market (including well-known tech names) fell, it turns out our guy bought at the peak before a sharp $100 drop. When the price fell through key chart-support lines, he refused to believe that this stock—of all stocks—would continue its slide. He didn’t even entertain an exit. In fact, he soon doubled down, buying into his belief that this stock always rises and he could reclaim his loss. Yet more share price erosion followed and he tripled down. Ultimately, he lost most of his account balance because of emotion. He was infatuated with this stock.

To a degree, we’ve all been there. We know our weaknesses—becoming too attached, or getting fed up too soon. These are common signs you’re trading with too much emotion. Here are some ideas to help your brain keep your heart (and your gut) in check:

PROBLEM: Emotions snare us before we realize it. Few humans operate with ice water in their veins, so by design, we’re way too emotional for trading out of the gate.

POTENTIAL FIX: That’s where rules come in. Rules can override emotions. Rules help you snap out of it. For instance, establish not just one “next” move, but cover your bases for several scenarios, should your stock work in your favor or against you. Of course, setting up rules is personal. Rules are based on individual risk tolerance and investing goals. Every trader views the market differently, based on their own perceptions and their own trading history. Rules might extend to setting stop losses, or might include stringent risk-management limits on how much you trade on a daily or weekly basis. What does apply to all: establish rules in advance of putting a trading plan in motion. It’s a bit like chess. When you can, anticipate the next several possible market moves, so you can be prepared to respond without hesitation or self-doubt.

PROBLEM: You set rules but abandon them, either mid-trade because of fear, greed, over-excitement, and so forth. Or, you change rules between trades.

POTENTIAL FIX: Consider the power of routines. Steeling yourself against the ups and downs of markets won’t happen overnight. But stick with it and you’ll soon rely on the comfort of routine. Once you’re on the right path, your rules will serve as bridges over everything from pot-holes (that hot stock pick a neighbor gives you) to canyons (economic catastrophes).

PROBLEM: You’re trading too much or too little to stick to a routine. If you trade on a “daily” timescale where potential buy-and-sell pricing signals come but once a day, yet you check your trades or charts throughout the day, you’re inviting emotion. After all, your signals (your rules) stipulate you can only take one action a day, at day’s end, for instance. So checking more often can be a strong sign that you’re too emotionally connected to your trade. It works the other way, too. Are you avoiding your routine, and why? Have unfriendly market conditions for your particular trading strategy, or have losses, made you a bit despondent?

POTENTIAL FIX: If you’re feeling antsy, go for a walk. If you need longer or more frequent breaks, change up your routine. For instance, schedule your daily workout in the middle of the day, to break up your trade-checking obsession. Consider a one-week challenge and go on an information “diet” that avoids market “entertainment” on TV or elsewhere. Just set a firm date for coming back on board and stick to it. You don’t want to risk missing out on information that could lead to trading opportunities.

PROBLEM: You’re not willing to take responsibility for your trades.

POTENTIAL FIX: These days, it’s easy for individual investors to sometimes feel outdone by the scope and speed of an increasingly automated trading world. A missed trade, or an ineffective stop-loss, was wiped out by the big boys, the complaint goes.

But the error often lies with the individual. The trade is too high-risk for the trader’s predetermined risk tolerance. Yet, instead of discarding the trade in search of a new one, he or she trades emotionally, believing the trade will make money with a tighter stop. The reality is that by keeping a tighter stop than the stock-price action indicates, the risk of the trade goes up. That’s because normal price action will wipe out that stop loss quickly—too quickly. That trader’s normal emotional reaction is to gripe that stop losses don’t work. It wasn’t the big guys behind that move, it’s likely that a herd of individual investors all set tight stops. Revisit your rules. Consider avoiding common and popular percentage stop losses. Instead, plan ahead and consider stop losses based on solid support levels for that stock.

PROBLEM: You’re experiencing personal struggles that creep into your trading. No surprise here. If life is especially hard, then trading emotions can be amplified even more than usual. Unusually high trading emotions can even be a canary in the mine for personal troubles. Self-evaluate and ask yourself if you have larger life-stressors than you realized. Have you experienced change, or death, in your family or social circle, moved your residence, lost a job, had a physical injury?

POTENTIAL FIX: Take a break from trading, which can include falling back on paper trading (for practice). Or, consider reducing your position size, and/or number of positions, while you seek remedies, or simply allow time to pass while your personal issues cool down.

PROBLEM: You believe that trading defines you as a person. Sure, most of us hold money in high regard. There’s nothing wrong with that. Money supplies our basic needs, but also feeds our bigger appetites. To many, money means freedom. By that reasoning, it’s no wonder emotion is automatically attached to trading.

POTENTIAL FIX: Trade because you love the routine (and what’s often, really, a grind). Trade because you love identifying the puzzle and solving it. Embrace mistakes and victories equally. Separate emotion from money (not easy to do). Consider all this and you’ll extend your trading life.

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