IN THIS CHAPTER

Avoiding mental mistakes and behavioral errors

Sidestepping emotional and evolutionary pitfalls

In this chapter, I present you with a list of ten psychological traps to avoid when trading — a list you should always keep in mind whenever you have anything to do with the stock market. By no means exhaustive, this list focuses on a small selection of the potential dangers you might face simply because psychological pitfalls are sometimes highly individualized and depend to a great extent on one's character, abilities, personal strengths, and personal weaknesses. (Addressing each instance is beyond the scope of this book.)

Dismissing Demo Accounts Out of Hand

Beginners are often impatient and tend to overestimate their abilities. They rush in, open trading accounts, and listen avidly as their brokers encourage them to get started trading right away. Beginners are generally greedy, and the dream of earning easy money makes them cocky. Fools rush in where angels fear to tread, and the inevitable occurs: The psychological trap snaps shut and they end up having to pay out a lot of money for lessons learned.

That's why experienced traders truly appreciate their demo accounts. With paper trading, you get a chance to test your strategies while patiently practicing your various processes and setups. By adopting paper trading, beginners can gain valuable experience by trying out different markets, different financial instruments, and different time frames with no financial risk. With a few dry runs in simulation mode, you can determine the right trading style for your personality.

Every pilot spends hundreds of hours in flight simulators in order to internalize techniques they have to be able to retrieve automatically in case of emergencies — trading simulations serve the same purpose.

Insisting On Flying by the Seat of Your Pants

You can understand why many traders want to remain flexible and trust their gut instincts when trading. Such desires will inevitably lead them down the garden path, however, because trusting your gut turns you into a toy that the market can play with as it messes with your emotions and exploits your genetic predispositions. Experience shows that if you have no proven trading strategies, clear processes, and a fixed set of rules, you will fail. Managing your money intelligently, as well as the risks to your money, is also a must. Without a plan in hand and without the proper money and risk management, you'll trade blindly, opening yourself up for yet another emotional trap to snap shut on you.

A select few experienced traders have, over the years, managed to learn the art of intuitive pattern recognition. They've developed a sixth sense when it comes to markets, and they rely on their gut instinct in a manner that is both well-thought-out and controlled.

Letting Your Ego Rule the Roost

Your ego can sometimes be rather an unpleasant type to have hanging around when you’re trading. It refuses to accept the fact that cognitive dissonance exists, so it tries to smooth out the dissonance by coming up with excuses for everything. Your ego forces you to suppress and rationalize all manner of unpleasantries that contradict your own convictions. Because it’s difficult to reconcile your ego with incorrect assessments, you fall victim to yet another psychological trap. When it comes to trading, dogmatism is quite a serious character flaw. The market is always right — even when you feel unfairly treated. That's something you simply have to learn to accept.

Successful traders have internalized their humility and remember not to take themselves too seriously. They follow the markets and take a piece from every suitable pie that comes their way. They trade the patterns they see, not their beliefs or hopes.

Believing That Goals Are for Wimps

Only those who know their destination find their way, said the legendary Chinese philosopher, Lao Tzu. Have you defined your trading goals? Do you know what time frame is practical for achieving them? What are your expectations? If you can't answer these questions, you'll end up falling into the next psychological trap. Without goals, you lack the motivation and mental strength necessary to survive difficult trading periods.

Prepare a proper business plan for your trading business with short-, medium-, and long-term planning goals as well as profit-and-loss accounting. You should know what you'll have left over after deducting all costs and taxes.

Attempting to Bat 1000

If you believe that you have to win 100 percent of the time, your downfall is inevitable. This particular psychological trap will snap shut on you in the shortest possible time. Losses are part of the nature of the trading business. Even with the best will in the world, there's no way you can avoid regular losses, even if you have an above-average hit rate. Consistent loss limitation combined with capital protection is the only sensible strategy. Never trade without protective stops.

Trade only with the money you can spare — never with the money you need for your livelihood. Sticking to this rule will protect your nerves.

Indulging in Revenge Trading

Okay, you're angry about an unexpected trading loss and you desperately want to get your money back. You feel like a victim. Anger and rage, however, only cause you to violate your rules, rendering you incapable of waiting for the correct entry signals, so you impulsively make too many trades.

That, in a nutshell, is revenge trading. You lose your emotional balance and the emotional trap snaps shut.

Never let tunnel vision take over. If you feel it happening, take a break. Physical exercise and relaxation techniques can help you clear your head.

Overtrading

Overtrading is often the result of revenge trading. You want to get your lost money back, so you place one order after the other in a manner that is both hectic and impulsive. You break all the rules and end up in a downward spiral. The combination of anger, overconfidence, and greed lead to the emotional trap snapping shut. You've lost control and you will (possibly) end the day with unnecessarily high losses.

Be like a hunter in a tree stand — on the lookout and patiently awaiting the correct entry signals. This should be the only strategy guiding your trade frequency. If other forces are pushing you, it's time to take a break.

Doubling Down to Recover Losing Trades

Let's say you're behind with a position and understandably annoyed. You have exactly three options when it comes to responding:

• Close the position or let yourself be stopped out according to your rules.

  This is brain-compatible trading. You accept the loss and move on to search for new entry opportunities in the market.

• Hold the position, remove the stop-loss limit, and hope its price will reverse.

  Wishful thinking isn’t a particularly effective strategy — you might miss out on better trades.

• Increase your risk and add more into a losing trade, in the hope that you will recover initial losses with the next small rebound.

  You move against the trend with an inflated position. Hoping for a reversal, you are essentially attempting to time the market.

The last strategy on this list is very risky but popular with traders and often works. But woe betide ye if the market doesn't play ball and your losses careen out of control. “Don't give up on losing trades,” you might think. This is the evolutionary deep rooted fight-or-flight response. Your psychological trap alarm bells should be ringing, because you now may be fully invested and dependent on a desired reversal that may not come. You've lost control and you’re incapable of action. The trend continues to move against you. The stock does not turn around, leading to substantial losses. Stress and anxiety are the inevitable consequences. The psychological pressure is too intense to bear and you close the position at a huge loss. Your trading account may even be exhausted.

The doubling down trading strategy is the main reason that traders fail. It is riding the tiger. Your trader psychology isn’t prepared for the emotional pressure if it goes wrong.

Learn to accept small losses and focus your attention on the next winning opportunity.

Failing the Marshmallow Test

Experts tend to recommend that you limit your losses and let your profits run, but that's easier said than done. Bad experiences with losses make many traders forget that wins need to be managed professionally. Otherwise, the next psychological trap snaps shut. This trap originates in our evolutionary development, related as it is to our biologically driven desire for immediate reward. This deep-rooted reflex leads to the fact that traders usually take profits too early. If you don’t manage to let your profits run, you won't be profitable with your trading over the long term.

Set clear profit targets for each trade, and when clear trends are apparent, pyramid your way to profits. This is brain-compatible trading at its finest. (For more on pyramiding as an investment strategy, see Chapter 11.)

Being (Unnecessarily) Contrarian

The old stock exchange proverb “The trend is your friend” seems to have fallen on deaf ears for many traders. It seems that it’s quite popular to go against the prevailing trend. This is based on the hope of perfectly timing a turning point or trend reversal, which essentially means desperately searching for signals that may initiate a turn. (If you find that you’re always saying to yourself, “The market should start correcting itself right around now,” you’re probably in a heap of trouble.)

This way of thinking may be a natural reflex, but it’s no trading strategy. The market isn’t interested in what you hope or believe. You build positions with the overall market trend in mind. Sailing against the wind requires an elaborate zigzag course. The psychological burden is correspondingly huge. The psychological trap snaps shut again. You will rarely succeed if your strategy relies on perfect timing — the resulting losses may burden you emotionally.

Resist the urge to build up long positions in falling markets and short positions in rising markets. You'll never find the perfect entry point. Go with the market, not against it. Your psyche will thank you for it. The only things that take off against the wind are airplanes.