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Dealing with Biases and Emotions - Part 2

In this chapter, we will continue with where we left of in the previous chapter and talk about the rest of the important ways of dealing with biases and emotions.

Abhishek Chinchalkar
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In the previous chapter, we spoke about some measures that one could take to efficiently deal with emotions in trading. We will continue with the same discussion in this chapter and talk about the other important ways of dealing with emotions.

Focus on the present:

When it comes to trading, a good way to manage emotions is to focus on the present rather than digressing into the past or thinking too much about the future.

Talking about the past, thinking too much about the trades that you missed or those that went wrong will only trigger an emotion of disappointment and regret. This is toxic, as it can affect your future trades. For instance, you could refrain from taking good trades as a few of your past trades went bad, you could take excess risk to cover up for the recent losses you suffered, you could trade based on a bad setup just because you decided not to pull the entry trigger on the previous trade which unfortunately worked very well, etc. As you can see, digressing too much into the past could negatively influence your mind.

Talking about the future, no one can predict the outcome of a trade with certainty, no matter how strong the trading setup is. Hence, before initiating a trade or when in a trade, it is important not to get obsessed with the future and have thoughts such as what if I suffer a loss, what if I exit my position at the target price but then the price continues moving in the direction of my position etc. Doing so would unnecessarily increase your stress level and might cause you to take an erratic decision, such as booking your profits too early, holding on to your winning trade even after the target price has been met despite you setup suggesting otherwise etc.

Hence, stay fully focused on the present. Adhere to your trading plan, stay disciplined, identify strong and convincing trade setups, take trades with appropriate position sizing and risk management strategies, and stick to your trade unless the trade setup (and not your emotions!) informs you to act in a particular manner. This way, you would ensure that emotions do not get the better of you.

Trade only on days when you are mentally and physically ready:

As a trader, you don’t need to trade every single day or try to capture every single price move. Instead, you should trade only on those days when you spot good trading opportunities that adhere to your trading plan and risk-reward expectations. If not, it is better to stay on the side lines and wait for clear trading signals to emerge, rather than jumping on board with low conviction. It is also worth mentioning that you should ideally trade only on those days when you are mentally and physically prepared to trade. If not, your trading performance could take a hit.

Let us understand this using an example. Let us assume that it was your birthday yesterday. You celebrated the birthday with your friends and family, had a lot of food and drinks, and were awake for most of the night. You only managed to sleep for an hour or so. Today, you are not only feeling quite tired and low on energy but also feeling quite sleepy and have a heavy head. Under these circumstances, would it be appropriate for you to trade? Probably not. As you are not at 100%, your ability to think logically is likely to be affected. You might react to trade setups that you usually don’t, or vice versa, and override your trading plan. In short, your decision-making ability could be impaired because of the emotions that you are under.

Hence, before you start trading on any given day, asking yourself questions that would help you assess whether or not you are prepared, both mentally and physically, to trade on that day. If you are not prepared, you could consider taking a day off rather than risking your capital and then regretting why you chose to trade that day.

Not all Emotions are bad:

So far, we have talked about how to manage emotions when trading. We have also said that emotions cannot be altogether eliminated and that we must learn to manage them and live with them. However, one thing to keep in mind is that not all emotions are bad. In fact, some emotions are very much needed to make sound and logical trading decisions. For instance, when you spot a very good trading opportunity that adheres to your trading plan, your conviction and excitement for that trade will surge. It is this feeling that will tell you to initiate the trade. Now, imagine what would happen if there were no increase in conviction and excitement after watching a good setup. Chances are that you might not initiate the trade.

Another instance when emotion might turn out to be beneficial is when you need to take a decision quickly, such as in an instant. For example, let us say that you are holding a long position in gold. Your rationale for the trade is that you expect US interest rates to remain low for the foreseeable future. Let us assume you entered the position at 45,000 with a 10% stop loss and a 20-25% target. Your view is shaping out to be right and gold has steadily risen to 51,000 within a few weeks. However, one day, the Federal Reserve chairman makes a surprising comment that the Fed is considering to start hiking interest rates a couple of years down the line. In reaction, gold declines to 50,100 within minutes. As the rationale based on which you bought gold is in threat and as the decline is swift, you might need to act quickly and close out the winning position than to risk seeing the profits dwindle. Your emotions, in this case, can help in processing and analyzing the incoming data faster and act quickly. So, as you can see, emotions might help in certain situations where timing is crucial, such in a fast moving market.

Mindset before, during, and after a trade:

As we know by now, having the right mindset is a very critical part of trading that can separate success from failure. The mindset of a trader can vary depending on which phase of the trade cycle he or she is in – before executing the trade, during the trade, or after exiting the trade.

mindset-tree

As you can see in the image above, this process is repetitive. You spot a trading opportunity (the ‘before’ phase), execute the trade and are now in the trade (the ‘during’ phase), exit the trade at some point (the ‘after’ phase), and then the process repeats again. These are the only three phases in a trade cycle, but they keep repeating. Each phase needs a trader to deploy a different kind of mindset to manage the position(s) as efficiently as possible. Let us talk about this more.

Before entering the Trade:

In this phase, the foremost objective of the trader must be to identify a sound trade setup that adheres to his or her trading plan and objectives. Various aspects of the trade must be diligently studied in this phase such as:

  • The strength of the setup
  • The odds that the setup could work out
  • The position size for the trade
  • The stop loss and target for the trade
  • Reward-to-Risk ratio (RRR) etc.

As an example, let us assume you are technical trader. In this phase, you would thoroughly assess the charts and identify trade setups with an RRR acceptable to you, see how convincing the setup is, ensure that the signal generated in the time frame of your choice is in sync with the time frame of one larger degree, identify entry levels for the trade, identify logical areas where profits/losses could be booked/covered etc.

So, as you can see, all the due diligence and decisions pertaining to executing a trade happen at this phase. As a result, your trading knowledge and experience will be critical. Meanwhile, emotions will also come at play in this phase. One such emotion is your conviction and confidence in the trade setup. Without this, you might not execute the trade. Hence, it is necessary to have such emotions. We call this positive emotions that are needed when trading. On the other hand, the negative emotions that shouldn’t influence your decisions in this phase are those that spill over from the prior trades, such as fear and greed.

During the Trade:

Once a trade is executed and you are in it, the next step is to manage your position(s). In this phase, it is very crucial to control your emotions and stay disciplined. You need to stick to your trading plan and hold on to your position(s) as long as the incoming information suggests you do so. Whatever decision that needs to be taken relating to entering the trade must be done in the first phase only (before entering the trade). Once the trade is initiated, you must then be fully committed to it rather than worrying about things such as:

  • Did I enter at the right price?
  • Is my position size appropriate?
  • Is my trade setup strong?
  • I didn’t take this factor into consideration, which could affect the trade
  • Wish I had not traded this security and had instead traded some other security etc.

All these are negative loops that will cause emotions to take over your mind. This in turn would make it difficult for you to calmly assess incoming information and make a logical decision about whether to stick to the initial plan or make amendments to the trade.

After the Trade:

Once a trade is exited, it is time to sit back and review the trade. You need to find answers to questions such as:

  • Did the trade work out as expected?
  • If the trade went right, did it go right for the right reason or was it mere luck?
  • If the trade went wrong, why did it go wrong?
  • Did I act based out of emotion?
  • Key learnings from the trade etc.

Carefully assessing the trade will help you to build on your strengths and improve on your weaknesses. Again, even in this phase, it is important to keep emotions at bay. You shouldn’t get obsessed with the result of the last trade. Fear, greed, and overconfidence are some key emotions that could get into your mind from your previous trade. If you fail to control them, they could spill over into phase 1 again, when you are on the lookout for trade setups.

So, as you can see, each phase needs a different approach or mindset. By knowing this, you would understand how to manage your emotions in each of the phase and ensure that they do not influence the decisions you take. This, in turn, would help you in developing your skills as a trader.

Next Chapter

Trading Suggestions and Guidelines

1 Lessons

In this brief chapter, we will discuss guidelines and suggestions relating to Trading Psychology and emotional well being.

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