Home Advanced Psychology and trading The Psychology of Risk Taking

The Psychology of Risk Taking

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It is a natural habit among non-professional traders to hang on to their losses and watch them grow. They are lured by fantastic profits and ultimately fall into the loss trap. There are many psychological reasons why they fall into the loss trap. You should be aware of them, to avoid falling on that trap, as well.

Why do you fall in the loss trap?

Framing

– Your mind is framed unknowingly in a way, it gets trapped in a loss trap. In this mindset, you see things for what they actually are not. There are three types of frames in trading which lead you to a loss trap and keep you in it.

  • The first one is the loss is not a loss frame. When it comes to making decisions with respect to the loss in trading, people try to make it seem less painful or even acceptable. For example, buying an option, which is spent as a premium, is not considered a loss.
  • The second one is the percentage frame. You should think in terms of R-multiples because the percentage of risk on a $1000 account and on a $10,000 account are totally different. This can be understood when that percentage is converted to the actual dollar amount.
  • And lastly, it is the criterion frame. For example, a trader might perceive that the price of the stock has gone down a lot.

Explanation

-Explaining why certain things are happening according to their comfort also keeps people in loss trap.

People need a story behind a price movement. They need to know why. The fact is sometimes there is no explanation. Economists have trouble predicting.  Also, 99% of market analysts cannot predict. Chart analysis is just a scenario, and the market has a high proportion of randomness because it is composed of millions of participants, each with their beliefs and objectives.

Traders look for reasons to justify their position.  People use market theories and systems, not to generate low-risk ideas, but to rationalise their desire to enter the market or justify their losses.

Overconfidence

– You are always overconfident about your positions. You believe what you are doing is absolutely correct and ignore all other reasons which prove you This leads to self-deception and takes you towards a losing situation.

Most traders are interested in being right than making money. This leads to the common practice of which we have mentioned in the beginning, of holding on to a position in spite of knowing they are wrong.

Probability

– You would like to place your probability scale either to 100% or 0%. You never think of the probability is within the range between zero to a hundred. In simple word, you either lose big or win big. If not acting at the right time, you could lose your entire investment.

Commitment

– When traders become very committed to their position, they are not in a state to make wise decisions. At this time, they develop irrational behaviour and incur higher losses.

Emotions of risking

Superstitious behaviour

Superstition may reduce nervousness, but it can also produce losses. As a trader, you need to be flexible in nature and adapt to different market conditions. Superstitious behaviour is inflexible.

Superstition means following the same practice again and again, regardless of the consequences. A trader might believe in buying anything at only a particular time. This is sure to make him a loss. A person cannot separate himself from superstition because it can reduce his anxiety. Trading at a particular time may result in a big gain but is definitely not suitable for the next series of trades.

This behaviour has no relationship to market prices. So cannot give success. Now the trader is locked in the loss trap.

Social reality

Traders often make decisions based on social comparisons. Rather than studying market behaviour, position-sizing, determining when to enter and exit, they compare their choices with their friends. They see what are they buying or selling and how much profit has he made.

Social comparisons never help a trader in making the right decisions. Advisors, for instance, have such bad price prediction that they are used to predict if the price will go in the opposite direction. Advisors, too, are not correct with their predictions, and an average trader cannot make money with their signals.

People tend to follow an advisor based on his recent record. And after a few successful trades, there comes failure. The result is a loss trap.

Overconfidence and losses

People unintentionally mislead themselves. A person keeps false beliefs and continues to be in that state very long time. False belief increases the risk of failure since we have not taken a decision considering real facts. You repeatedly commit the mistake again and again and keep yourself in self-deception. People, also, usually refuse to concede they are wrong about a trade, even if they are losing money.

Beliefs are an important element of success. It is necessary to have a belief but not over-confidence. You need to filter out beliefs into different levels. In this way, you become flexible while trading. And flexibility is an essential component for trading success.

Subjective decisions

People should avoid risk when it comes to profit. They should not expose themselves to higher risk when it comes to losses. This means professional traders take wise decisions when there is profit potential. But average traders do the opposite and gamble. By doing that, the risk is higher and the chances of a loss rise.

This sure loss always exists when you are in a loss trap. It is comfortable in the minds of a trader to keep holding on to a loss hoping that it will turn in future. What the trader needs to understand here is that accepting a small loss by placing a stop loss frees him from loss trap.

Importance of time

In trading, time is a part of the rate of return equation. Your profits are very much dependent on time. Rate of return is calculated on a yearly basis. Time is an integral part of the futures and options market. If your trade is not performing for a long time, then you need to take immediate action probably because it is no longer a low-risk position.

Time is important, even from a psychological perspective. Time measures risk in two parts. First, the point of commitment and second, the point of no return. Many people are still unaware of how time is critically related to risk. Risk literally increases exponentially with a decrease in time.

Final words

Many traders fall into loss trap by ignoring reality. The only way to not be in a loss trap is by minimizing loses. And separating this emotion from you is not easy. You need to understand how this works and keep improving your knowledge.

That means every trade should be prepared using a neutral mind as if we were doing the job for other people’s money. Using our rational mind, and applying the trading rules defined for the current strategy, the trader should set the entry and an automated way to exit after a trade is taken. That way, when an exit point is reached, there should be no hesitation, avoiding the loss trap.

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