How do my Emotions Affect Trade Targets?

Mar 3, 2007: 1:20 PM CST

Have you ever sat down for you nightly analysis and wondered how far a potential trade might go?

Although the market is the final arbitor of how much profit a potential trade can make, we can adjust our thinking and emotions to capture either more or less of that potential profit.

Once you enter a trade, especially if it is related to a reversal or pull-back entry into an established trend, odds are highest for success at the entry point, provided we analyzed the market probabilities correctly. As the trade continues to work in our favor, odds of further continuation (without reversal) decline as the trade moves further in our favor. In dollar terms, a trade entered long at a support zone might have a 75% chance of success, but as the trade moves up $3 or $4 away from that zone (and nearing possible resistance), odds decline to 25% or 10% of further continuation.

So when is the optimal time to exit a profitable trade? Emotions – surprise – help determine the outcome more than probability if we are discretionary traders. At the correct entry point, fear may take over and cause us to do one of the following actions:

  • Enter the trade too late (by waiting for confirmation of our intended reversal/shift in supply/demand)
  • Pass on the trade (after waiting for confirmation and the ‘proper entry’ is further away now… but there’s still upwards potential)
  • Enter the trade properly, but stop out prematurely

On the flipside, Greed may cause us to do the following:

  • Enter the trade too early (anticipating a signal)
  • Hold on to the trade too long to the downside (when we enter and move our stop downward because “It has to work out!”)
  • Hold on to the trade too long to the upside (because it has “just a little more left!”)

Remember that your analysis is clearest BEFORE you enter the trade and cloudiest (by emotion) when you are IN the trade. Typically, your first instinct will be correct, especially if you have been trading for a while and have gathered sufficient experience.

I have found from my trading that I suffered from “Zone Exposure” that stemmed from perfectionism, the need to be right, and fear of loss.

In this example (CTSH, April 2006 – Daily Chart: TradeStation), let me oversimplify analysis to the following:

  • Stock in uptrend
  • Buy at pullbacks to the 50 period moving average
  • Target is slightly above most recent swing high
  • Stop is just below 50p MA

Your “perfect entry” is about $56.50.

Assume you find this ‘perfect pullback entry” on your nightly analysis and decide to buy in the morning. The stock gapped up to $58! Are you greedy and do your rush in to buy? Or are you hesitant and fearful, and pass on the trade entirely? What is the correct answer?

A signal, once valid, stays valid until it is invalidated either by the “stop” or the “profit” target (Hint: This is true on higher time-frame analysis). In other words, yes, you missed your perfect entry but odds are higher for more upside continuation than to the downside and you should STILL enter the trade (perhaps with fewer shares, though).

By the way, exit would have been around $62 or $63, depending on your initial parameter (how far above the most recent swing high you desire). Greed could have kept you in all the way to $64… and back down lower. Discretionary trading tests out best when you play for a small, fixed target and not an arbitrary large target. Emotions cloud these targets both at entry (fear keeps you out) AND at exit (greed keeps you in).

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Stop Placement Trade-off: Personal Observations

Mar 2, 2007: 3:46 PM CST

Ever wonder the exact place to rest your stops?

Sadly, there is no exact place and there is no magic formula. Placing your stop involves a trade-off between risk (in dollars) and probability of being triggered. Simply put, the closer your stops are to your entry, the less you risk, but the higher the probability of being stopped-out due to normal volatility. The further your stops are from your entry, the lower the chance of being hit, but the more money you will lose (unless you properly used position sizing).

These can be mathematically calculated and affect the end-result of any trading system. There is a difference, however, regarding this issue in mechanical vs. discretionary trading systems.

A mechanical system trader accounts for this, tests various methods for stop placement (Average True Range functions, swing highs/lows, moving averages, etc) and attempts to find the best trade-off. Results are derived from normal market movement and choice of entry/exit criteria.

A discretionary trader experiences a ‘double whammy’ when it comes to stop placement and end results. Emotions and discipline are factored into the equation in a non-linear, non-mathematical method that results in various outcomes that cannot be predicted. Stop placement becomes subject to the whims and emotions of the trader at the moment the trade was placed. Also, a discretionary trader may impulsively decide to move his or her stop either up or down and further degrade (or improve) the monthly/weekly results.

The outcome of one trade has little impact on overall trading performance, if a trader follows discipline and a tested system. This is difficult to comprehend for newer traders and experienced ones alike. As a discretionary trader, I still put too much emphasis on the current trade and wonder whether my stop will be “gunned” or if I placed it too far (and thus, should move it up mid-trade).

My problem occurs from entering a trade, placing my hard stop, then yanking it up to kill the trade when the market moves slightly against me, or remains ’stuck in neutral.’ I have found this to degrade my performance and increase psychological stress on me – rarely has moving my stop been helpful.

I have noticed many times that the market – regardless of timeframe or strategy – will signal a clear buy signal, move in the intended direction, stall, reverse, trade down at the ‘obvious’ stop-placement level, take out close stops, and then rally very quickly in the original direction as traders rally to get back in. I’ve been stopped out with “the crowd” more times that I care to admit and it’s due to “fear of being wrong” and my perfectionistic tendencies.

I will be writing an article soon to address this point and show examples of why both tight stops and loose stops degrade system performance, as well as moving stops based on emotion.

Please comment or contact me with your experiences and insights you have had with good and bad decisions related to stop placement. I look forward to hearing from you.

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Examining the “Right Edge” of the Chart – “What do I do?”

Mar 2, 2007: 9:11 AM CST

Whatever sparked our initial interest in trading, we all have to answer the same question daily: “What do we do at the edge of the chart?”

Even now, that question haunts me after I’ve studied my charts, examined the overall market, and scanned economic news. Even with all that behind me, when the trading day begins and I’m ready to execute my plans, that “second guessing” or nagging feeling of “what if I am wrong?” plagues me and I suspect many others. “What if the chart pattern doesn’t work out this time?” “What if I lose money?” “What if they gun my stops this time like they did last time?”

Although I know trading is a game of probabilities and uncertain outcomes, I still have to work hard daily to “silence the inner critic” and move on with my positive game plans and enter the trades with the proper stops and not watch every tick. Early in my trading career, these questions never entered my mind. I haphazardly entered trades based on momentum or a ‘hot news story’ and rarely considered the “what ifs” mentioned above. I made money until one day when I was supremely certain in the outcome (mega-profits) based on a magazine article in Forbes. I risked twice my normal size and – got burned. I lost not just all the profits I had accumulated (through greed) so far, but almost twice that amount above that initial zone. That was my ‘trading trauma’ that began the spiral into fear for me.

So, as we become professionals, we tend to focus much more on the “risk” side of the equation – as we must do – but I focused so much that it inhibited my performance in various ways. Trading is a game of balance between acceptable risk and reward; between greed and fear; between too much knowledge and not enough; between the professionals and the mass public; between the mature and immature (in our trading education). There are many pendulums we have to address when making decisions. For me, and I suspect for many others, the pendulum swung too far for too long into the “fear” and “risk” sides.

Our previous experience, our knowledge/education, and our personality (confident or fearful) affect how we address that “Hard Right Edge” of the chart and the questions we address when seeing it. Not only do we question whether we should put a trade on, but how many shares should I buy, how much should I risk, where should my stop be, where should I exit, how long will I hold this trade, if I hesitate, where is ‘too late’ to enter, is it too soon to enter, etc.

While this post can’t answer these questions, there are many resources online that can assist you in your anxieties and trading decisions. Use the evenings to study the markets and set-up your trades through scanning and chart annotation (as well as blog reading), write down your plans (plans written down have higher odds of execution), and execute your plans based on your written strategy.

Each success you experience in your trading will chip away naturally at the “fear of the hard right edge” of the chart.

BONUS LINK:

From “The Kirk Report”“Flip the Chart”
Kirk suggests we turn the chart upside down in order to cool over-bullishness (or bearishness) and examine the chart from a different perspective to help determine trading decisions. Worth a read.

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The Fear and Recent Decline

Feb 28, 2007: 10:33 AM CST

Needless to say, there was an overwhelming amount of fear that resonated throughout the market yesterday. Without addressing the specifics or reasoning behind the decline, as have been addressed by news sites and other blogs far superior to my new blog-in-development, I wanted to take a different approach and address some of the emotions of new traders behind the market action we just experienced.

Because of the steady market advance that we have witnessed since last August (following the 10% decline after May, 2006), we have been virtually unabated in our ascent and complacency. This is shown objectively by low levels on the $VIX index (around $10) and subjectively by various sources. We are hearing more talk of complacency at the least to near euphoria at the most, as new investors come into the market for the first time, especially after hearing of the 15% return of the S&P and Dow last year.

One anecdotal piece of evidence that I read recently came from Toni Hansen’s daily commentary where she noted that the recent Trader’s Expo in New York was so well attended and “busy” that she jokingly commented to another trader whether a top might be forming simply from this reality. She noted that the last time she saw attendance at these levels was the Expos of 2000 right before the great decline. We are also seeing Daytraders coming back to the scene in levels similar to those before the ‘crash’. The Expo ended Valentine’s weekend, and many new traders were so excited to put their new knowledge to work in the market, but what a wake-up call they got!

We traders have more experience than those who freshly step up to the plate; as such, those who have survived have simply outlasted these ’shock’ events and adjusted our approach to the market accordingly. If you lost yesterday, you have a battle scar to show! I suspect a lot of trading careers may have been abruptly ended yesterday before they began.

When confronted with such a blow, two approaches arise:

1) Take your punishment, and walk away with tail tucked. Sustain a trading trauma, increase fears, decrease confidence, and engage in avoidance behaviors.
2) Take your loss, realize you got greedy, realize market realities, store these lessons away, learn from the loss and catalog it, engage in stress reduction techniques, move on to trade another day and hold fast to your risk management profiles.

I know each successful trader can point to one or two trades that “got them” and changed their world perspective. I can. In fact, true professionals will be able to point to multiple occasions. Don’t lose heart if you were blindsided by this drop. Don’t throw in the towel and quit. Believe me, I’ve been there with you not long ago. All of us who stay in the game simply do so because we learn how to overcome these events, and file them psychologically differently than those who walk away with crushed emotions and expectations. Take time away from the game and gather knowledge, but please come back to the game.

Please stay with me here at afraidtotrade.com. I am working to develop a community of traders and knowledge to help you overcome fears. Please be careful, be patient, and mind your risk!

 BONUS LINK:

Oda at Options the Easy Way  posted a great, quick summary of the recent decline and encourages us to stick with our plan and our discipline and keep finding trade entry points.  Yes, a lot of people got hurt, but we must press on and keep analyzing and finding trades that are congruent with our system. Please check it out.

4 Comments

We Took a Hit, Captain

Feb 27, 2007: 11:14 AM CST

There’s no avoiding it – the market got clobbered this morning before the opening session and has not managed to recover as we just breached the noon hour. Although the instinctive move might have been to “fade the gap”, realize that this gap was largely fundamentally driven with a possible contagion effect and struck with the indices on technical sell signals. The technical picture was shattered this morning with that gap and the market (both Dow and Nasdaq) has violated their rising 20p and 50p Moving Averages on a significant candlebar. The caution I warned about yesterday was warranted as the long, uninterrupted uptrend is now called into question, although it is still not invalidated (that will come with a lower low, lower high, and a strike-out below the new lower low). Caution is now strongly warranted as we see how severe the “Asian Contagion” from China, strength in the housing sales and consumer data (which may lead to higher probabilities of an increased interest rate hike) along with Greenspan’s recent warning of “a higher than anticipated probability of a recession”. Clearly, it is now time to raise your stops, take at least partial profits from any remaining position trades, and be very cautious with new buy swing set-ups. My guess is that we will be seeing a plethora of shorts begin to set-up if we make a lower low and then retrace upwards from that low. Please be careful out there and mind your risk management parameters you have set in place.

On a surprising note, I have rarely seen Breadth levels so divergent (as of Noon, EST)
Advancing Issues: 487
Declining Issues: 2,770

Another internal is shockingly high:
The TRIN reads just over 4.50

Also, in the last two sessions, the $VIX has risen from around 10.0 to 13.40. Quite the “fear” spike.

In the meantime, look at these ‘blood in the water’ charts.

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