1/12/2013 Trading. Psychology. By Lester Koh, Research Analyst. NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

Transcription

1 1/12/2013 Trading Psychology By Lester Koh, Research Analyst NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

2 Introduction Trading psychology is one aspect of trading and investing that is seldom focused, on, given the hype of new trading techniques, stock screening skills, and new technical indicators being released. It has been said that trading psychology plays a major role in determining a trader s profitability, but is only given minute amounts of attention until one has experienced the full impact of the market in the form of losses. Well, let s take a look at this trader below: This trader has been trading single standard lots and felt that he has become consistently profitable. Having earned an average of 30 pips per trade in 10 trades with a few controlled losses on the same currency pair, he increases his trade size to 5 lots. After another 10 winning trades and consistent losses, he gains more confidence and ups his lot size to 10. But his trade goes south. However, due to his pride and overconfidence, as well as emotions of hope, he hesitates as he cannot accept his losses. The market plunges even further, and by the time he cuts his losses, he has lost 200 pips. All his accumulated profits thus far were wiped out. 1 lot x 30 pips = $300 x 10 trades = $3,000 5 lots x 30 pips = $1500 x 10 trades = $15, lots x -200 pips = $20,000 Fearful and afraid, the trader goes back to trading single lots for 30 pips. It will be awhile before he gets his consistency back, and when he does, he will repeat the whole losing process again unless he learns from his mistakes. Such is the story of most novices (and even professionals) in the market. Most of them will get a few winning trades, get overconfident and greedy, begin to ignore their own trading rules, and is killed by the market. It s as if the market is baiting them, waiting for that one mistake where it can kill the trader. Such is the plight of traders who do not manage their emotions, their greed, and their fear. Thus, it is important that traders learn to manage their trading psychology, so as to reduce such occurrences from happening. Greed and Fear Bulls make money, bears make money, pigs get slaughtered is an old Wall street saying that cautions against greed and impatience. It basically means: do not let greed affect your judgment when you trade or invest. Periods of greed and fear can be observed by looking at crowd psychology during market seasons and self-fulfilling prophecies. As an example, the market is generally more optimistic from the last 5 days of December to the first 2 Days of January. This is often known as the Santa Claus Rally and has averaged 1.6% for the S&P 500 from The Santa Claus Rally is even more reliable when it is absent, often indicating bear markets or corrections in the near future.

3 Another observation of trading psychology can be more clearly seen in the month of May, when market corrections tend to happen (together with October, which is notorious for historical market crashes.) The Wall Street Adage Sell in May and Go Away, is a reflection of the market s fearful crowd psychology. In addition, as these patterns become more defined and are observed and followed by more people, they become more consistent and act as self-fulfilling prophecies. This results in crowd psychology moving towards a particular emotion, though certain exceptions do occur. On an individual level, a lack of control of one s trading psychology can lead to fatal trading mistakes which can wipe out your trading account. It doesn t take much effort or skill to initiate a trade. Just click buy, place your buy price, and confirm your order. Of course, some might argue that there are better ways to make an entry such as doing fundamental analysis, technical analysis, and even running simulations. However, the problem comes here: when do we exit the trade? Most traders will probably agree that the difficult part is knowing when to exit our trades, whether it is a winning trade or a losing trade. This is due to our psychology. We face greed when our trades are winning, and we hope that prices will rebound when our trades go south. Some common thoughts would be: I think that the price of the stock will still go up, even though it has finally reached its intrinsic value Since I m in profits, I ll stay in the trade a little longer I ll wait for a small correction before I exit I ve got a gut feeling that the price will rise even higher In the long term, these plans will never work for the trader blinded by greed. A common scenario would be: You initiate a trade with a profit target of $300 based on your analysis. (or some other person s analysis, for that matter) The stock price increases and you now have unrealized profits of $350, $50 more than your initial profit target. Even though you have an extra $50, you decide to let the trade run. The stock price hits a resistance at $350, and all indicators show an overbought status. One day later, you find that the trade has retraced, and your profits now sit at $300. Rather than exit the market with your original profit target, you stay because you want that $50 back. You hope that it will return back to its original level, even though your analysis tells you otherwise. The trade declines further and you are now left with $150. You feel the warning bells. Fear seeps in. Your adrenaline starts pumping. But within those feelings is a glimmer of hope. A hope that your trade can recover. I won t get that $50 for sure, but the stock price should increase back to my profit target! The next morning you check your trade again. It s as if the market has read your mind! Your trade now shows a profit of $300 again. Now you think: If the trade profits can increase to $300, there must be enough momentum to push it back to its original level at $350! I will watch and wait

4 From $300 the stock slips to $200. You hesitate. $200 becomes $100. Still you hold your ground, ignoring your analysis. $100 becomes $50, just enough to cover the buy and sell trading commissions. You feel that you have nothing to lose and continue to hold on. After all, you won t lose anything, right? The trade slips into the red. It hits the stop loss that you planned for yourself. Still you hope Greed is the factor that holds us back from claiming our profits, even though they have reached our targets. Fear is the factor that holds us back from cutting losses. From the time your trade was profitable until you suffered losses, there were about 5 reasons to exit the trade. However, due to your emotions of greed, fear, and baseless hope, you deviated from your trading plan and allowed the trade to become a loser. The only time you should continue to hold on to your trade is if a thorough, logical reassessment of the market and the trade gives a sufficiently strong reason to. Other than that there is no reason to stay in the trade. The market has proven time to time that breaking your rules is never a good approach to trading. Using all the investment knowledge you have at your disposal, all you need is one excuse not to stay in the trade. Cut your losses early, and let your profits run It is more important to lose consistently than to profit consistently. It is pointless to make 10 profitable trades at $50 each and have a $1000 loss on the eleventh trade. It will be better to make inconsistent profits and have consistent losses amounting to a total of 10-20% of your total profits. (That being said, if you are losing consistently and also not profiting, something must be wrong with your trading plan!) Lose as little as you can and make as much as you want. What s the point of making many consistent profits, only to be forced to leave the game by one huge losing trade? The key here is to aim for consistency, and remain in the game long enough to learn and become profitable. Remember Warren Buffet s first 2 rules: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. Money Management How then, can we lose consistently while letting our profits run? There are many tools to help you lose consistently and maximize profits. Stop losses, profit targets, and time targets are one of the few ways to maintain discipline.

5 You ve done your research, both your fundamental analysis and technical analysis was good, you ve searched, screened, and researched, and finally found an ideal candidate for your portfolio. The financial statements of the stock look great, with increasing earnings year on year. It is currently trading under fair value a bargain at its current price. With this understandable confidence, you initiate a large buy position and add it to your portfolio. But imagine that, the next day, as you check the news on the internet, you discover some bad news the Securities and Exchange Commission is launching an investigation for accounting fraud into that same company you just bought. The market reacts with panic selling and your stock tumbles. In addition to the famous Enron debacle, the market has had its fair share of corporate scandals. Accounting firm Arthur Andersen was convicted of a felony for obstruction of justice when it shredded allegedly important evidence that was relevant to the Enron case. ImClone experienced an insider trading scandal when it s CEO Samuel Waksal and his family sold shares ahead of public announcements that the FDA was refusing its application for a cancer drug. Waksal resigned and was arrested. Merrill Lynch was fined $100 million for hyping stocks to investors that its own analysts described as excrement. WorldCom was accused of fraudulently cooking its books to allegedly create $3.8 billion of revenue, resulting in a criminal investigation launched by the Justice Department. As can be seen from the above cases, sometimes, no matter how hard you work, the stocks you buy can flop and its price can fall quickly. Sometimes, the companies may be innocent, but the mere news of an investigation can cause psychological panic selling. Remember, once a stock drops by 50%, its price will have to recover by 100% in order for you to reach the initial price at which you bought not even profits. As the losses increase, the gains required to get back to where you started from goes from unlikely to near impossible. The company can even go bankrupt and you can even lose 100% of your investment. Statistics have shown that while % losses are not out of the question, % gains is rare. One would definitely want to avoid such scenarios because at some point, a loss of capital so large can occur, highly reducing the possibility of ever achieving any financial goals with what is left in the portfolio. If one is young enough, new capital can be injected into the account. However, for those near retirement, starting afresh probably isn t an available option. Thus, the key here is to limit your losses to levels that can be sustained. Diversifying your holdings to a certain extent, looking at different industries, and adding tactical, non-correlating assets to your portfolio mix combined with diligent fundamental and technical analysis can help control your portfolio s overall profitability and volatility, but none of this will help to prevent large, unacceptable losses at the individual level. Thus, it is important to use Stop Losses coupled with constant monitoring to ensure losses are limited. Using Stop Losses A stop loss is any method of setting a pre-determined selling price that, if hit, will cause the security to be sold. For long positions where the aim is to buy low and sell high, a stop loss price will usually be below the purchase price or current price. For short positions where the aim is to buy high and sell low for a profit, a stop loss will tend to be above the current price. Using stop losses forces the trader or investor to decide in advance the maximum price decline that will be tolerated before the stock is sold.

6 Stop losses are beneficial as it helps to take the emotion out of the decision making process. It is easy to know and understand the importance of limiting losses, but it is often difficult to let go of a stock once you ve bought it. It is especially hard to sell your stock at a loss I know, I ve experienced it many times! A typical scenario I ve experienced would be something like this: the stock is down, losses are at $1000, and my mental stop loss has been triggered. As I begin to click the sell button to cut my losses, my adrenaline starts pumping, disappointment floods my mind. Think of what I could have bought with those one thousand dollars! What if I sold the stock and it bounces back? What if it becomes profitable? Such thoughts often flow through one s mind when cutting losses manually, and was one of the most difficult hurdles I ve had to overcome while investing with real money. This is because much effort and evaluation has been put into the stock buying process and cutting your losses would be the same as admitting you were wrong. At the same time, the fear of losing money combined with the hope of future price increases begin to cloud your decision to cut your losses. Gaining the emotional strength to cut such losses is not easy and can only come with practice and experience (and more often than not, losing some school fees to the market.) However, such experiences often prove to be useful as long as your account survives long enough for you to learn from it! After all, a mistake paid for with real money is definitely more memorable than one made with paper trades. An old Wall Street adage advises the trader to cut your losses and let your profits run. However, most people seem more comfortable with selling their winners early lock in profits and holding their losing stock just in case they bounce back I d know, I was one of them (and occasionally still am!) It is of utmost importance to understand and admit that using a stop loss will cause you to sell things that you don t want to sell yet. You must also be prepared for the reality that a stock you didn t want to sell but that triggered your stop loss may increase in price right after you sell it. This is okay! Just see it as insurance for protecting yourself from the bottomless nature of unlimited losses. In addition, when such things happen, one can learn a few things: how to better set your stop loss, and how to be more disciplined. After all, the goal is long term consistent profitability, not short term profits followed by busting your account! Setting the Stop Loss Price How far away from the current price should you set your stop loss? That depends on the security you are trading. A quick glance at the price range and volatility levels should give you a price that is objective and reasonable. Another factor that comes into play would be your risk tolerance. If the price of the security you re considering routinely moves outside of your comfort range, don t buy it. Another factor would be the time frame involved in holding the security. Generally, the longer the time frame, the farther away your stop loss (and profit target) should be, so as to account for volatility in the market. There have been some instances where I have turned short term trades into longer term investments by shifting to a trailing stop (which is a stop loss price that is set a range below the c urrent price e.g. 5% below current price. If the price increases, this trailing stop increases as well, and is triggered only when the current price drops by 5%) and increasing my profit target. While that can be a good strategy to let your profits run, one must be able to differentiate it from breaking one s trading rules or escaping from the pain of triggering a stop loss. There must be logical reasons for doing so.

7 How to place a stop loss? A stop order can be placed with your broker for securities traded on a stock exchange. The main advantage, as mentioned earlier, is that this automates the selling process for you. However, a potential problem is that once the stop is hit, it becomes a market order. This means your shares will be sold at whatever price is then being offered at the market, even if its fallen right below your target to a price substantially below your stop (although this is definitely still better than not setting a stop loss). As an example, assume you own 1000 shares of a stock purchased at $10 per share, with a stop order at the price of $9 per share. The stock opens at $9.50 and over the course of the day, drops to $8.98. Since your stop has been hit, your stop order becomes activated as a market order to sell 1000 shares. The next bid that hits the market for your stock is 500 shares at $8.75. Your first 500 shares are sold. The next bid is for just 250 shares at the price of $8.50. You sell 50 more shares. Your last 50 shares sell for just $8, which was the subsequent bid. You ve managed to exit your position, but at an average price of just $8.50 $0.50 lower than your original stop loss price. Your proceeds before commissions are $ $500 less than what you were hoping for when you set your stop order. (And that s before commissions!) Another alternative is the stop limit order. This is used to set the minimum price you ll accept if the stop loss price is hit, but you run the risk that your shares won t be sold at all if no one wants to pay at that price. (Although this is much less likely in increasingly higher liquidity situations). As with the above example, let s assume that instead of a stop order, a stop limit order is used on the same 1000 shares at $9 per share. Once again, when the stock trades at $8.98, your stop loss is activated, but this time as a limit order for $9 or better. This means your shares will be sold only if you can get a price of $9 or higher. This would mean that the 3 bids above will not cause your shares to be sold, because they are below the limit order price. If all the rest of the day s trading takes place below $9, You won t sell any more of your shares. However, should the price trade within a range and move back up to $9 before moving down again, you would be able to sell your shares at the price of $9 or more. With the stop order or stop limit order types, your target price does not change by itself. In times of rising profit, you might want to consider raising your stop loss over time. As an example, for an investor whose stock price is rising consistently, he or she might want to increase the stop price to 10% away from the latest price. This would involve manually changing the stop orders every time. To solve this problem, the investor can use trailing stops. Trailing stops follow the price of the security higher as it rises but stays constant if the price begins to fall. To calculate your trading stop, multiply the current price by your stop price percentage and subtract that number from the current price to get your stop price for the day. For those trading Forex, subtract the number of pips set as your stop loss from the current price of the currency pair.

8 While most brokerages do offer some form of stop loss orders to automate your loss cutting, there are some exceptions. In such cases, constant monitoring and journaling must be done when trading. Stop loss levels must be recorded and followed in a disciplined manner with little or no room for exceptions and discretionary rule changing. Letting your profits run A good way of maximizing profit would be to take it in stages. For example, if you have 10 lots in a long position and are making some money, sell half of them (5 lots) and let the remaining ones r un. If the stock price increases a little and hits resistance, take 4 lots and let the last lot r(do note however, that closing your trades in such a manner may lead to more commissions as you are selling at different times! Hence, the key here is proper planning and cost/benefit analysis) You can also use a trailing stop to protect your profits until you get stopped out. Additionally, one can also use goal stops which is the process of tightening the trailing stop percentage e.g. from 10% of the latest price to 5% so as to lock in even more profits. This works by setting a target price for which the trailing stop will be tightened, and doing so when that price is hit. To conclude, aim to keep your losses consistent, let your profits run, fine tune your trading strategy to ensure you are profitable, and never forget your rules. Remember, the market will always slay the greedy and irrational trader. Constant Monitoring is Important but do not be influenced by market noise! It is of utmost importance, as mentioned earlier, to keep a constant eye on your portfolio and record down not just mental stop loss prices, but also time targets. This is even more so when you are planning to leave the market for a period of time (and it doesn t matter how short that period of time is!) If stop losses are available and you are leaving the market, it may be wise to tighten them, especially if the time targets of the securities in your portfolio clash with the time where you ll be out of the market. Examples include holidays, examinations, or just plain sloth. In the case where stop loss orders may not be available, it may be wise to exit your positions, especially if you plan to be away from the market for a long period of time. I experienced this personally when I went overseas for 16 days without closing out my positions (I cou ld not set stop losses). The profits turned into a loss when I came back from my holiday. I was blinded by greed most of the securities in my portfolio were at highs and exceeded my profit targets. I was undisciplined while I did set stop loss targets, no time targets were in place. I was distracted by hope hope that the profits would continue to increase, and that I would be able to lock in these profits by the time I returned from my holiday. Do not make the same mistakes I did. It took a large amount of time to recover from those losses and become profitable again, and the thought that I could have avoided such a mistake still haunts me today. Do not make the same mistake I did.

9 In summary: Have you set your stop losses, profit target and time targets? Have you done a cost-benefit analysis of your stop orders, and profit targets, taking into account commissions and taxes? When changing stop loss prices, time targets and profit targets, do you have sound logical reasoning for doing so? Are you sure it s based on logic and not a stupid excuse for your emotional fallacies? If you are leaving the market for a holiday have you exited your positions or do you have stop loss orders in place? Do you have internet access overseas? Are you able to monitor your portfolio? Have you recorded all the mistakes you made with regards to your trading psychology in a trading journal? If not, do you remember them as you trade? When looking at your current portfolio and your unrealized profits and losses, what is going through your mind? Is it greed, fear, or hope? Stay Disciplined, Stay Emotionless (when trading). research@nusinvest.com if you have any questions! We will do our best to answer your queries! This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives, financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this research material are subject to change without notice NUS Invest