Trading Psychology : Prospect Theory

This Prospect theory explains why Traders get it wrong when coming across with certain trading decisions, such as whether to sell out of a stock which is now showing a loss. Most people are unwilling to take losses, They don’t want to accept they are wrong,

This dislike to taking losses is a very powerful nature. People do not seem to view a paper loss as real, so that we can postpone the painful feeling of losing money. We are also unwilling to admit that we made a mistake with our initial buying. Selling is an acceptance of failure.

Conversely, if a stock price has risen we are happy to take profits and sell quickly. The main motivation behind selling stock positions at a small profit appears to be to correct and it will minimise regret. If the stock fell back to our buying price after reaching a new high, we would criticize ourselves for not taking profits earlier when the price was high. Selling Stock also confirms that our initial buy decision was correct. We hunger to get that confirmation as quickly as possible.

In contrast prospect theory says we tend take more risks in a losing position to get breakeven, But we want less risk when winning in any position, preferring a quick and certain gain to a chance of losing our profits. Both of these effects are at odds with classical financial theory, which says that people’s actions and preferences for risk are unrelated to whether they have made paper profits or losses.

Trading Psychology: Early Loss Taker Will Always Beat The Early Profit Taker

Unfortunately, in trading taking small profits quickly and letting losses run longer is almost always a blunder.

Research done on similar rules, across variety traders, confirm this finding. The early profit taker rule, which mimics our natural instincts, does worse than a rule which does the opposite.

A Classic example of this is given in Victor Niederhoffer’s book Education of a Speculator.

At this point in the story hedge fund manager Victor has a large long position in silver futures. We join him in early 1980 when the Hunt brothers, who had been pushing the silver price upwards, are about to book profits, which will cause the price to drop drastically: “I decided to set my loss limit at 50% of my winnings. I instructed my future wife, Susan. ‘Do not listen to my appeals if I wish to double further the quantity or ask you to cancel my original decision. If the losses reach 50% of the winnings, sell everything out.’…

Some rumors about liquidation by the Hunt brothers had hit the market… I immediately placed a call to Susan ‘Undo me. Disregard everything I said before’ … My faithful companion followed my original directions.” Susan closed the entire position and Victor lived to fight another day. But how can we ensure we stick to our strategies

Trading Psychology : Sticking to the Strategy

There is no point developing and implementing a systematic trading strategy unless you can stick to it. Suppose you make a New Year’s resolution to follow the let tjr profits runa and take the losses early rule. Like most such resolutions, it will probably prove hard to keep.

When a long position in Nifty futures hits the 100 point, stop loss the early loss taker rule has set you will probably start making excuses: “The fundamentals are good. They have not changed. I will just hold on a bit longer.Just this once. If it goes down 50 points – which it won’t – then I will definitely sell.” You might not even close at a 100 point loss, kicking yourself for not selling earlier, and

Continue to hang on for the rebound that never comes, until the pain is unbearable and you close out. A small profit would also prove tempting, with its own litany of excuses why you should deviate from the rule, just this once.

Trading Psychology : Meddling 

This process of interference by mind is called meddling. Meddling is caused due to the biggest cognitive bias of all: overconfidence. We think we are cleverer than the Trading system, as we have developed it and in fact we are. We think we know more than the trading system and we do; the system focuses on a narrow set of quantifiable inputs, whilst we can analyse many kinds of complex information. Just as news, there is a war going on, inflation is high, us markets are falling etc., we know more than the trading system and we do; the system focuses on a narrow set of quantifiable inputs, whilst we can analyse many kinds of complex information.

We think being clever and having more information on real time data and news, that we will make better decisions – but we usually don’t, thanks to cognitive biases.