Know thyself. How to keep your emotions in check when trading

IG recently conducted comprehensive research to uncover valuable insights into how psychology impacts real world trading decisions. Throughout the project, our experts studied the results of over 30 million closed trades across 15 markets, examined third-party academic studies, analysed data from multiple surveys and consulted with several industry thought leaders. The following article has been developed using insights gained from this research.

‘Don’t get too emotional’. It’s something we’ve all heard – or said ourselves – at some point, the implication being that emotions often drive us to make unwise choices. For traders, staying cool, calm and calculated isn’t always easy, especially when the market you’re trading is moving around rapidly. But if you’re looking to maximise your success, then it’s important to understand how emotions can affect your decision-making, so you can take active steps to make rational decisions.

Read on to explore the psychology behind how the emotions of fear, greed, hope, frustration and boredom impact your trading performance – and how to prevent them getting in your way on the path to success.

Fear

What does 'fear' mean in trading?

Fear in trading is the distress caused by the threat of loss, real or imagined. Fear can help to keep impulsivity in check, but it can also cloud decision making, causing a trader to close out a position too early, or miss out on a profit by being too afraid to open a trade.

Research by Lee and Andrade found that when fear was induced in a group of traders – by showing them clips from horror movies – only 55% of participants wanted to hold on to their positions. This contrasted with a control group in which fear was not induced, where 75% of the traders still held onto their positions.1

IG's own study showed that less experienced traders were more affected by fear and uncertainty when compared to professional traders. One explanation for this is that professional traders might have experienced more losses than traders who are just starting out, and so could be more comfortable with the risk of loss to secure a profit.

Equally, more experienced traders might have more discipline, meaning they recognise the benefits of closing a losing trade, rather than letting it run. The below graph demonstrates that the average loss is substantially higher than the average gain, which is perhaps due to the tendency of traders to let their losses run out of fear.

Average profit and loss in points

How can traders limit the effects of fear?

One way to limit the effects of fear is by approaching every trade with a plan, and by placing stops to reduce any losses and limits to lock in profits. If you have carried out sufficient technical and fundamental analysis before you open a position, and if your stop or limit is placed at the correct level, you should be confident in the fact that you have done everything in your power to prevent unnecessary losses.

Technical analysis is a great way for you to identify the best levels at which to place a stop or a limit. One form of technical analysis which enables you to do this is a Fibonacci retracement, which you can use to highlight levels of support and resistance.

Greed

What does 'greed' mean in trading?

Greed in trading is the impulse to act in irrational ways in pursuit of excessive gain. It manifests itself when a trader gets overenthusiastic and trades beyond their means – opening more positions than usual or holding on to positions for too long because they are chasing an even greater gain. In doing so, they might incur a heavy loss and may even wipe out the profit they have already made.

Greed has a lot to do with how often an individual trades, or equally, if a trader thinks that they should be trading more. A study by Graham, Harvey and Huang found that, when measuring a trader's confidence levels, a small gain in their confidence resulted in a similar increase in their trading frequency². This tallies with IG's survey, which found that an average of 42% of respondents felt that they should invest or trade more, with a lack of knowledge or confidence likely to be holding them back.

However, while traders might feel confident enough in their abilities to trade more, research by Park, Bin Gu, Kumar and Raghunathan has found that those who trade more often might actually achieve lower realised returns.³

How can traders prevent greed?

You can prevent greed from affecting your positions by becoming familiar with risk management strategies. Risk management strategies can help you to understand the risks associated with trading with leverage and why you shouldn't overexpose yourself to the markets.

One of the most effective ways to manage risk is to use a risk-to-reward ratio, which compares the potential loss to the potential gain for each trade you open.

An example of a risk-to-reward ratio would be if you placed a $300 trade that had the potential to realise a $600 profit. In this scenario, the risk-to-reward ratio would be 1:2 as you stand to gain twice as much as you stand to lose should your predictions be correct.

Hope

What does 'hope' mean in trading?

Hope in trading is a feeling of expectation and is often linked to optimism, confidence or experience. While all traders need to have some hope when they open positions, there can be downsides of excessive optimism. For example, a trader might hold on to a losing trade because they believe that it will reverse its trend and become profitable.

A study by Nofsinger revealed that traders find it difficult to cut losses because they view it as an admission of defeat. Traders hope that the asset will recover so they won't have to face the realisation that it may have been a bad decision to open the position⁴. In fact, our data shows 50% of traders held on to their losing positions for longer than was ideal, and as the graph below demonstrates, this led to losses that were far greater than their gains.

Average profit and loss in pounds

Hope can also determine how frequently an individual trades and how much they risk. For example, Germain, Rousseau and Van state that 'optimistic traders purchase more or sell smaller quantities, whereas pessimistic traders sell more or purchase smaller quantities than if they were realistic.'⁵

How can traders prevent hope from impacting their decisions?

One way you can prevent hope from impacting your decisions is to set out a number of goals – possibly in a trading log or diary – for your time on the markets. By setting goals, you know exactly what you should be hoping for from your trading, which means that you could be less inclined to let losses run out of frustration.

Equally, a set of goals can help to manage expectations, so you could be more inclined to be happy with what you have earned. This could prevent greed getting the better of you and stop you from opening new trades in the hope of earning more.

Frustration

What does 'frustration' mean in trading?

Frustration in trading is the annoyance traders feel when the markets have behaved in a way that they didn't anticipate. The largest cause of frustration is loss, but it could also be that a trader didn't gain as much profit as they thought they would.

The time of day at which a trader incurs a loss, or a series of losses, can have a big impact on how frustrated they feel. Research by Coval and Shumway shows that traders who experience morning losses are about 16% more likely to assume above-average afternoon risk than traders with morning gains.⁶

Adding to this, IG's survey found that inexperienced participants were more highly impacted by negative emotions than experienced traders – meaning that they might be more affected by the frustration caused by losses.

How can traders prevent frustration?

Frustration can be prevented by understanding that you will almost certainly incur losses during your time on the markets. The important thing to remember is that losses can be managed by attaching stops and limits to your trades.

Stops will restrict your losses, while limits will lock in your profits at a level which you see as favourable. As a result, stops and limits can help to take the decision about whether to close a trade out of your hands – so you could be less inclined to let your losses run out of frustration, or in the hope of eventual profits.

Boredom

What does 'boredom' mean in trading?

Boredom in trading is the tendency for traders to get fed-up with the financial markets and feel that their routines have become monotonous. This can cause a trader to deviate from their plan and take unnecessary risks to try and stir up some excitement.

Boredom might arise if the markets are moving slowly, or if a trader hasn't profited as much as they thought they would. As a result, a trader might start sensation seeking to combat boredom – searching for varied, novel, complex, and intense sensations and experiences.⁷

However, this can lead to excessive risk taking. Wong and Carducci carried out research in which they devised a 'sensation seeking scale' (SSS) to show how susceptible participants were to sensation seeking and unnecessary risk taking due to boredom. On the SSS, male participants were more susceptible to sensation seeking and boredom than their female counterparts.⁸IG's survey provided similar evidence, with 50% of men willing to risk losing some of their capital for improved returns, compared to just 35% of women.

How can traders prevent boredom?

The effects of boredom can be prevented by using a demo account to create and test new strategies in a risk-free environment. This could be beneficial if you are fed up with your current trading methods and want to try something new.

Demo accounts enable you to trade without risking your own money. Traders can still get thrills from trading on a demo account, and it can even help them to strengthen their own abilities to pursue greater profits on the live markets.

Footnotes:

¹Lee and Andrade, 2011
²Graham, Harvey and Huang, 2009
³Park, Bin Gu, Kumar and Raghunathan, 2010
⁴Nofsinger, 2005
⁵Germain, Rousseau and Vanhems, 2005
⁶Coval and Shumway, 2001
⁷Zuckerman, 1979
⁸Wong and Carducci, 1991