Stock traders go through several different phases in their quest to be a master of the market. One of the most difficult to master is to remove one’s emotions when trading. You can be a great stock picker, do well at managing risk, and still not succeed as a trader if you fail at emotional mastery.
Mastering one’s emotions enable you to have patience with your profits and no patience with your losers. While it seems easy to say that you have to follow your trading plan, actually doing so is much more difficult. The emotional attachment that most of us have to money is what makes it difficult to follow our rules.
To achieve this, you must take the focus off of the money. The financial risk has to be taken out of the decision-making process. Easy to say, but challenging to do.
Here are some techniques to help you achieve emotionless trading:
1. Don’t take more risk than you can tolerate
Taking too much risk is the most common reason traders hang on to their losers and sell their winners too early. Taking too much risk attaches an anchor to your risk management techniques, hindering your ability to have a positive expected value on your trades.
You can change this by lowering the amount of risk that you take. Many traders then find that there is not enough upside to motivate them to trade at all. Without a way to make good profits for the capital that you have, the trader may start to take on more risk as a way to chase performance.
However, you can increase the upside potential of your trades without adding more risk by scaling into your positions. Add to your winners as the trade is working in your favor. You don’t have to take on added risk by doing this. You can use the profit of your initial positions to mitigate the risk of your additional positions. Add to your winners. Never add to your losers.
2. Change your financial focus
I often advise that it is best not to look at the profit and loss summary for your trades. Doing so causes you to get wrapped up in the current gain or loss on your positions, heightening the fear or greed that you feel about the trade. Instead of making decisions based on the chart, make decisions based on the financials.
It’s not realistic for people to not check their trades and know whether they are making or losing money. Therefore, if you have to look at your trades, rather than focus on the current profit or loss, consider what you will make or lose if your trade is stopped out.
If you buy 1,000 shares of a stock at $10 and the stop is at $9, you stand to lose $1,000. That is even if the stock is trading at $10.25. That is the loss exposure you have at the exit door.
Suppose that this stock rises up to $12 and you move you stop up to $11. While your position is currently up $2,000, if you get out on the stop you are actually only going to make $1,000. You have to put your focus on the number that coincides with your exit point. Do not focus on where you are at now.
If you think, “Hey, I am up $2,000 on this trade!” you start to attach your emotions to this number. If so, you are going to be more likely to not exit if the stock falls back to $11, where you only make $1,000. You had expectations for a $2,000 profit, hoping it would go higher. Exiting at a lower price is painful and many people hang on hoping for a turnaround. Count on what you have, not what you are hoping for.
3. Write down a plan and trade it
The emotion of a trade can cause some mental breakdown. When executing a trade, emotions can cause you to stray from your trading rules. Having a written plan to go to during confusion will help you stay on track.
The plan does not have to be long or sophisticated. I don’t think that a trading plan should be more than one page. In it, you should have your rules for entry, risk management, scaling and exit. There should also be a process of review so that you work to improve your rules and their execution.
Ideas have a greater value when you write them down. Take the time to draft a trading plan before you make another trade.
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