One Enemy Number One for Traders is Emotion

It’s 6:00 am on the west coast and the US stock market is set to open lower. The headlines are that Apple shares are  trading sharply lower in the pre-market as a direct result of the company lowering their earnings guidance due to the impact of the Coronavirus. Since Apple (AAPL) is the biggest stock (measured by market capitalization) in the Nasdaq 100, and is also a component of the Dow Industrial Average and the S&P 500, it has major influence in the movement of Stock index Futures.

When markets become volatile the usual response is an emotionally charged set of actions. On one hand, the bulls see any pullback as a buying opportunity as the market has been charging upward making new all-time highs almost on a daily basis. Their fear of missing out on the upward move is allayed temporarily because the selloff provides an opportunity for them to buy at lower prices. This cohort welcomes the bad news.

Then, as the market advances, this fear of missing out also sets in motion a dynamic that usually doesn’t end well. That dynamic is chasing trades (when individuals buy high with no regard to what price they pay for a stock or Futures contract). They are buying high late into the move with the expectation that they will sell higher; but risk a strong chance of price reversing on them. If momentum is strong they may capture a profit, but it’s a tricky game as this is not particularly a low risk strategy. Many times, they find their fear of missing out was misplaced as the market environment can change rapidly and the pullbacks can turn nasty, punishing the Johnny come lately in the market.

The other emotion evoked during an expansion in volatility is the fear of giving back profits. As the market continues higher, many more market participants have been accumulating shares and, depending on when they purchased their shares, have garnered profits along the way. They will fiercely guard their gains and any signs of the market falling sharply will trigger selling from these nervous Nellies as they are usually trading without a plan.

Even traders who are trading with a plan can succumb to emotion. For example, the fear of losing leads traders to move their stops prematurely. This often results in many trades stopping out at breakeven. Alternatively, if, knowing the trade was well-planned, the trader had let the trade play out, they would likely have reached their target.

Another common mistake that traders who are fearful of losing make, is that of trailing their stop. In my experience this tactic, more often than not, will lead to trades being exited before their designated target. This can be a source of frustration for many traders. The only exception would be if a trader is accepting of what the outcome of trailing a stop brings and she incorporates that into her trading strategy.

All and all, emotions play a big role in trading mistakes. The way we deal with those emotions will help us move forward to become better traders. The best way I know to quell those emotions is to devise a very mechanical, rule based process that has been put through its paces. In other words, the process has been tested, and produced positive results over a large sample size of trades. As I have written in past, the process must give a trader the three essential elements of trading: low risk, high profit and high probabilities. If you don’t possess this process, then emotions could govern your actions in trading, and I can tell you from personal experience, that is a losing proposition.