Are You Trading Based on Emotion or Probability?

No matter how hard you try to fight it, trading will test your emotional stability. It simply cannot be avoided. We as human beings are wired with an emotional, reptilian brain that will over-rule our rational and probabilistic thinking especially when dealing with money.

Moreover, Alexander Elder states “Thinking about money interferes with decision making” (The New Trading for a Living). New traders look at open profits and think about the ways they can spend the money they just made in the market. Elder continues by saying “Professionals focus on managing trades; they count money only after trades are closed.” In other words, professionals focus on process not outcome. 

Additionally, when a novice trader is experiencing a large drawdown or a series of losses he or she is more inclined to hold losing positions below initial stops with the hope that the prices will recover. The inability to sell a losing position stems from our emotional brain. For example, emotional traders will take profits quickly and losses slowly. Daniel Kahneman, the father of behavioral finance, calls this loss aversion. He states that “The sure loss is very aversive and drives you to take risk. Loss aversion is present even when the amount risk is relatively small to your total wealth. Losses loom larger than corresponding gains” (Thinking, Fast and Slow).

In addition to being loss averse, traders can exhibit the Endowment Effect which states that individuals place more value on the things they own than others would. This can cause you as a trader to rationalize staying in a losing position because you perceive that the market is undervaluing your holding. In trading, you need to remain emotionally unattached to your positions and stay focused on your process. Make no mistake, this will be a challenge as you fight your innate emotional propensities but succumbing to behavioral biases is a surefire way to destroy a positive expectancy system.

Understanding mathematical expectation will be instrumental in developing as a trader. Too often novice traders exhibit innumeracy or the inability to understand the basic notions of probabilities. In other words, beginners will trade to the house’s advantage with a negative expectancy system whereas a professional will trade with the player’s advantage or positive expectancy system.

Contrary to a novice trader’s opinion, positive expectancy systems are often simple and have very few parameters. This simplicity will create robustness that allows for the system to work in multiple markets and over many market cycles. When designing a trading program avoid the temptation to over-fit your system to past market data as this is more likely to create an unstable system. In fact, Elder advises that traders “try to de-optimize instead of optimize a system.” In doing so, you may assume more losses or lower winning percentage, but simpler, more robust parameters will come with equally larger gains and better risk-adjusted returns.

The losses incurred when trading a positive expectancy system are understood to be a businessman’s risk to the professionals. No system is perfect, however the risk management protocol can be tailored to keep your emotions intact. Traders define their potential loss by the fraction of the account put at risk in a trade. Following sound risk management rules will expose you to an acceptable level of risk whereas letting behavioral biases impede your trading process will open the door for potentially dangerous losses.

Taking time to understand your emotions and probabilities when trading will help you design a system to combat your weaknesses and exploit an edge. Elder says “The intellectual demands of trading are modest, but its emotional demands are immense.” If you are looking for a place to begin, start by learning a Trend Following system which naturally combats human biases by cutting losses quickly and letting gains run. Moreover, trend systems produce positive expectancy which will put the odds in your favor for profitable trading without emotional interference.

As always, please feel free to contact me with any comments or questions. Thanks for reading.

John