What is Emotional Trading?
Emotional trading describes the behavior of allowing emotions to affect trading decisions, such as entries, exits, or trade management. Trading emotions can be triggered by various factors, with one of the major ones being influenced by currently having strong losses or profits in open positions. Emotional trading is characterized by subjective decision-making and a strong tendency to act on known behavioral biases.
The Challenge of Emotional Trading
Having emotions during trading is inevitable and not necessarily a bad thing. However, the danger of emotions in trading is that they can impede rational decision-making. It is naturally very tough for traders not to be emotionally affected by the profit or loss they currently have when opening a new trade. It is quite common to see that a trader might become more aggressive or risk-averse when having an open position in profit or loss. On one hand, a trader may feel enthusiastic, maybe even unbeatable, when having a significant profit in an open position. On the other hand, a trader might feel aggressive, annoyed, or scared when having a position deep in loss.
Often, emotional trading is only considered when strongly negative emotions arise, such as trading more aggressively to recoup current losses in other positions. Surprisingly, strong positive emotions can also lead to underperformance. A very common bias that comes into effect here is Mental Accounting Bias.
Mental Accounting Bias in Trading
Discovered by Nobel Prize-winning Richard Thaler, Mental Accounting Bias finds that humans classify and value money differently depending on how they earned it, even though logically, the value of money is the same following the fungibility of money principle. This effect is especially prominent in windfall situations.
Imagine this: you just won a large sum of money in a casino. Because the money was gained easily through a windfall, most people will be more keen to use this money to gamble because it was earned easily through the casino. Rationally, the money they won in the casino should be treated the same way as money earned, for example, through a job or money that is put aside for retirement, as it is completely interchangeable. However, we are oftentimes not rational in such situations and treat money differently. The same can be seen in trading. With large positive open P&Ls, meaning traders have just gained a significant amount, traders tend to trade more aggressively and, in turn, make irrational decisions.
Different Forms of Trading Emotions
These are not the only formats of emotions that may affect your trading. If bad experiences happen many times before, a trader might also act more cautiously in case of open winning trades, not wanting to risk the daily profit. Therefore, placing a very tight stop loss or using smaller position sizes.
Managing Trading Emotions
In general, trading emotions are not inherently bad. However, good traders must learn to manage their emotions and know when it is better not to trade. This requires transparency, complete openness to oneself, and the ability to track and detect one’s own emotions and behavior. This is one of the toughest things to learn on the path toward profitable trading. Additionally, certain emotions can help the trader because they enable quick and to-the-point decision-making, yielding good payoffs.
Importance of Self-Analysis in Emotional Trading
As seen through the examples above, there is no one-size-fits-all rule on what kind of emotion happens in which situation and which emotion might be loss-making or profit-making for you. Therefore, it is crucial to analyze yourself based on data, detecting your special strengths and weaknesses to boost your trading results.
How Hoc-trade Detects Emotional Trading
Hoc-trade identifies a negative correlation between the profit levels of open positions and the performance of new trades opened during this time. If either high profits or high losses negatively impact performance, emotional trading is detected.
This example shows that the trader’s decision-making is negatively affected when facing losses in open positions, leading to an overall loss-making trend. Emotional trading might be driving the trader to take on aggressive risk. In fact, comparing the average loss in pips and return, we see the return is even worse than the pips’ view, indicating that the trader used larger lot sizes in those trades, further exacerbating the negative payoff.
Strategies for Managing Emotional Trading
Having identified that such a pattern can negatively impact trading performance, traders may want to detect the emotions driving the thoughts when opening trades while having a loss in other trades. Using a trading journal to list your own emotions can be a very helpful tool in such instances. As a first mitigation action, the trader may choose to limit the lot size during such scenarios, limiting the negative impact.
Monitoring Progress
When you are actively working on your trading behaviors and want to check your progress, it is advisable that you also check your trade history with one-month and three-month charts, allowing you to compare your payoff in the recent past to your total performance. In your trading output, you may also identify specific trends or views, such as outperformance during times with a small profit in open trades. You can leverage such knowledge and actively seek trading situations like this.
Conclusion
Emotional trading can significantly impact your decision-making and overall trading performance. By understanding and managing your emotional trading biases, you can improve your decision-making and overall trading performance. Use self-analysis, data-driven insights, and tools like hoc-trade or trading journals to track and mitigate the impact of emotions on your trades.
Ready to approach your trading with more rationality? Connect your trading account with Hoc-trade for free today and experience the power of AI-driven assistance in managing your emotions and optimizing your trades.
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