Check out this informative piece from our friends at Investing Answers:
Investing is like a roller coaster. The ride -- sometimes smooth, sometimes volatile -- tests every investor's emotional extremes. It has certainly tested mine.
In order to be a successful trader, you have to take the emotion out of the equation as much as possible. That can be a tough assignment, especially when your account seems to skyrocket one day and slide downhill the next.
Throughout my trading career, I’ve pinpointed three ways emotions can inhibit successful trading. If you can keep them in control, you can take a lot of the agony out of trading.
Overconfidence in the Short-term
When I began trading, I was so confident in my abilities in the market, I started spending my millions before I even made them. I was sure of my success; I had seen the stock market rise and rise and rise and really had never experienced a bear market.
But my emotions led me to make my first mistake: counting on expectations of the recent past to predict the distant future.
I was very much into trading stock options, which can provide huge gains if used correctly. Unfortunately, I abused them.
Instead of using options as they were intended -- to limit risk -- I used them to get rich quick. I placed huge bets, investing tens of thousands of dollars in technology stock options, only to see them fall.
And rather than regrouping and looking at the problems with the trades, I stubbornly threw more money at the problem, fully believing that there was a move ahead and I just had to wait for it.
Unfortunately, this never happened, so I lost big and I had my first big exam at the "school of hard knocks." My first introduction to large losses had to do with my lack of experience at the time. But emotions played a huge role in these lessons learned.
How Greed Can Leave You Penniless
Fear and greed drive the stock market, which is why we see stocks that are oversold and overbought all the time. As the stock market rises, our emotions start to tell us that this will last forever. We suddenly want to buy everything, imagining all of the great things we could do with our new wealth. But somehow we can still end up disappointed, dealing with big losses and a small portfolio.
When I was a broker with a large firm, I was able to watch greed take over a client's trading behavior -- and his account -- firsthand. Our client put his $50,000 retirement account into a trading account with us. At the height of the Internet stock boom, when anything related to the Internet was experiencing growth that was out of control, this gentleman decided to use call options as leverage -- in attempt to score even larger gains.
Using this strategy, this trader took his account to nearly $50 million in just six months time. But his success wouldn't last long. Greed took over his emotions and he continued to take huge risks that ultimately wiped out most of the fortune he made. While he did eventually start to put cash into safer investments before the market turned, he still lost millions.
Handle Risk by Getting a Grasp on Emotion
In the 1980s, the stock market was in the midst of its largest bull run. As a result, traders started selling puts as a way to make profits.
Selling a put is a bet that the underlying security will continue to rise. When a put is sold and the security rises, the seller can win big.
But there are big risks involved. If the security collapses, a trader can expect to receive a margin call -- basically a phone call from the broker asking the trader to put more money in their trading account to cover costs or face account closure. It's exactly what happened to thousands of investors in 1987 on Black Monday. Traders that had made profits dozens of times without a loss were suddenly broke and desperate. Betting heavily for larger profits, they were overconfident -- and paid dearly
It's important to remember that no one can confidently predict what the market will do in the short-term. Some investors might get mad because a trade they exited rose higher and higher -- that if they had stayed in the investment, they may have made more money.
It's true that they could have made more money. But consider the following example:
When I am driving and approach a red light at a desolate intersection, I hate waiting for the light to turn green. It seems like there is never a car coming. Even so, I still choose not to run right through the intersection. You probably do the same thing too.
So why don't we run the light? Because there's no point to taking such an unnecessary risk. Sure, I might make it through without any trouble dozens of times. But one day, I might not see the car coming -- and it could cost me my life. All because I didn't want to wait a few minutes at an intersection.
The Investing Answer
One of the worst mistakes any trader or investor can make is to not have a trading plan. Have an exit point set up before entering a trade. If we know what we are going to do ahead of time, it helps take emotion out of the equation.
The most important investing lesson I ever learned was that every investor should have a plan of attack and should follow this plan. Without one, we're exposing ourselves to risks that we don't have to be exposed to. Trust me, when our portfolio suffers, it can impact our entire life, not just our trading account. Many marriages and lives have been ruined because of a lack of trading discipline.
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