Many large losses are initially small losses that are allowed to become large due to a lack of trading discipline.
Consider "five hazardous attitudes" common in trading psychology:
The Five Hazardous Attitudes
|Attitude||What someone with this attitude might say …|
|Anti-Authority||Don't tell me what to do!|
|Impulsiveness||This looks wrong. I've got to do something right now!|
|Invulnerability||That won't happen to me!|
|Arrogance||It hasn't been done because I haven't tried it yet!|
|Resignation||Oh well, I guess it doesn't matter now.|
Each of us may possess one or more of these hazardous attitudes to some degree. It is critical for a trader to identify which is most prevalent in his or her personality and behaviors.
Look back at your worst trades and ask yourself, "Which of the above statements, if any, best describes what I was thinking at the time?" Admittedly, this is not easy, as we generally dislike examining our errors.
However, this exercise is enlightening because we often learn something new about ourselves. Completing this exercise is a prerequisite to learning how to apply the appropriate correcting behavior.
The Five Improved Behaviors
|Attitude||Corrective thought process|
|Anti-Authority||Follow the rules. They are there for a reason.|
|Impulsiveness||Stop. Consider your alternatives— then act.|
|Invulnerability||It can happen to you. No single trader is bigger than the market.|
|Arrogance||Is the potential reward really worth the consequences of failure?|
|Resignation||You are not powerless! You can make a difference!|
Each hazardous attitude has a specific thought process which can help replace the defective reasoning that caused the attitude in the first place. Now let's learn how to apply them.
Applying Better Habits under Stress
In order to make meaningful changes to our trading behavior, each of us needs to implement corrective thought processes when we are trading under stressful conditions. When reviewing your trades you may learn that the hazardous attitude most likely to affect your actions is impulsiveness: the desire to react quickly, sometimes too quickly. For impulsiveness, the corrected behavior is: "Stop! Consider your alternatives. Then act."
So, how do you remind yourself of this when you are under stress and need it most? One idea is to anchor or associate that habit with something around you when you are trading. It could be a "stop sign" drawing on your computer screen or a particular picture or item in your work space. The key is coming up with something that reminds you to pause, think, and remember your trading plan and these important questions:
- Am I adhering to my pre-determined risk tolerance?
- Am I determining where to exit a trade if it moves against me before I enter it?
- Am I placing stop orders in the market, or am I using a "mental stop"? (Unless you possess the discipline of a professional athlete, a mental stop is not a stop.)
- Are my stops too loose? Am I staying with the trade after the trend has clearly changed?
- Am I taking too big a position, in other words, buying too many shares?
Now, let's turn to some corrective steps for the other hazardous attitudes.
Hazardous thought: "Don't tell me I need to cut losses. This stock will come back!"
Corrective thought process: as traders, we must be disciplined. Above all, we need to be disciplined when it comes to exiting losing trades and letting profits run. Losing trades are inevitable, because nobody gets it right all the time.
Keep in mind that setting up stop loss orders can automatically reinforce this discipline. It's important to note, though, that there is no guarantee that a stop order will be executed at or near your stop price.
Profitable trades are also inevitable because nobody gets it wrong all the time either. Here, it's important to let those profits run, rather than grabbing them at the first hint of a price pullback. Carefully monitoring the trend and not acting too quickly is the goal here.
Hazardous thought: "This stock is going to be the next big winner. Why worry about diversification? I'll put everything into this stock and get rich!"
Corrective thought process: Wait a minute—this is greed talking! Remember this stock could go down. How would I feel if I have everything invested in it? One way to control this type of impulse is to limit position sizes for each trade. Establishing position sizes as a percentage of your trading capital is one way to help you maintain discipline in the face of tempting trades. Understand the importance of portfolio diversification.
Hazardous thought: "I've made money in the markets. I got this figured out."
Corrective thought process: Have I really done that well? Is it worth risking my entire future on my ability to trade? By periodically examining your trades you can honestly answer that question. There are a number of ways to assess your trading but we recommend looking at absolute performance. Then, be prepared to spend some time learning from the results.
Hazardous thought: "Oh well, that stock's drop has really cost me. I guess it is done now. There isn't anything I can do but wait and hope it comes back."
Corrective thought process: As Schwab's Chief Investment Strategist, Liz Ann Sonders, says: "Hope is not an investment strategy." There's a continual focus on loss control in trading for a reason. Always remember to identify and follow the trend in price and when the trend changes to down, exit the trade as soon as possible—with the goal of keeping losses small. Create rules for yourself and follow them to help control losses.