We’ve all been there!
You look at a chart, suddenly see the price move in one direction or the other, or the charts might form a short-term pattern, and we jump in before considering risk/return, other open positions, or a number of the other key factors we need to think about before entering a trade.
Other times, it can feel like we place the trade on automatic pilot. You might even find yourself staring at a newly opened position thinking “Did I just place that?”
All of these terms can be summed up in one form – the impulse trade.
Impulse trades are bad because they are executed without proper analysis or method. Successful investors have a particular trading method or style which serves them well, and the impulse trade is one which is done outside of this usual method. It is a bad trading decision which causes a bad trade.
But why would a trader suddenly and spontaneously break their tried-and-true trading formula with an impulse trade? Surely this doesn’t happen too often? Well, unfortunately this occurs all the time – even though these transactions fly in the face of reason and learned trading behaviours.
Even the most experienced traders have succumbed to the impulse trade, so if you’ve done it yourself don’t feel too bad!
How it Happens
If it makes no sense, why do traders succumb to the impulse trade? As is usual with most bad investing decisions, there’s quite a bit of complex psychology behind it.
In a nutshell, traders often succumb to the impulse trade when they’ve been holding onto bad trades for too long, hoping against all reason that things will ‘come good’. The situation is exacerbated when a trader knowingly – indeed, willingly – places an impulse trade, and then has to deal with additional baggage when it incurs a loss.
One of the first psychological factors at play in the impulse trade is, unsurprisingly, risk.
Contrary to popular belief, risk is not necessarily a bad thing. Risk is simply an unavoidable part of playing the markets: there is always risk involved in trades – even the best structured transactions. However, in smart trading, a structure is in place prior to a transaction to accommodate risk. That is, risk is factored into the setup so the risk of loss is accepted as a percentage of expected outcomes. When a loss occurs in these situations, it is not because of a bad/impulse trade, nor a trading psychology problem – but simply the result of adverse market conditions for the trading system.
Impulse trades, on the other hand, occur when risk isn’t factored into the decision.
Risk and Fear
The psychology behind taking an impulse trade is simple: the investor takes a risk because they are driven by fear. There is always fear of losing money when one plays the market. The difference between a good and a bad trader is that the former is able to manage their fears and reduce their risk.
An impulse trade occurs when the trader abandons risk because they’re afraid of missing out on what looks like a particularly ‘winning’ trade. This impulse emotion often causes the investor to break with their usual formula and throw their money into the market in the hope of ‘not missing out on a potential win’. However, the impulse trade is never a smart one – it’s a bad one.
If the trader identifies a potential opportunity and spontaneously decides they must have the trade – and then calms down and uses good strategy to implement the transaction – then this is no longer an impulse trade. However, it the trader disregards a set-up trigger or any form of method in making the trade, they’ve thrown caution to the wind and have implemented a bad trade.
Result of Impulse Trading
Impulse trades typically end in one of three ways:
The ill-conceived impulse trade results in a loss (odds-on outcome!)
The impulse trade results in a loss, but subsequently becomes the trigger of a valid setup. The trader ignores the setup for the sake of their previous loss and misses out on the next win.
The impulse trade that actually wins. Occasionally an impulse trade will work out in the trader’s favour. This is sheer luck!
From another viewpoint, however, a winning impulse trade is bad luck because it reinforces the taking of a bad trade simply due to a good outcome.
One winning impulse trade will spur on more and under the right market conditions some of these may also have good outcomes. It’s a natural tendency for traders to focus on winning outcomes – regardless of the quality of the decisions which caused them.
This is a particularly dangerous situation for traders as all of their negative trading traits (which would usually cause losses in normal market conditions) are being reinforced.
As one would expect however, more often than not, bad trades made from bad trading decisions will result in losses. When the market eventually ‘rights itself’ and the aberration which allowed some bad trades to have good outcomes disappears, the trader is left confused as to what constitutes a successful approach, and is undoubtedly nursing big losses.
The trader has failed to focus on the quality of the trading decision, but rather than the quality of the outcome. In this way the impulse trade is little more than gambling, because gambling is based on pure chance whereas good trading is based on calculation and reason. There is risk inherent in both trading and gambling, but in the former, risk is accommodated and is simply an expected outcome in an overall proven winning strategy.
One must remember at all times that trading psychology is an incredibly important part of setting up a winning trading career.
If one doesn’t remain calm, a few winning impulse trades are going to be outweighed by the eventual losing impulse trades, and cause a whole bundle of trading psychology issues down the track.
Curing the Impulse Trade Urge
So, how does one know that they’re at risk of an impulse trade, i.e. how does one stop the problem before it develops?
If you’re feeling panicky about your portfolio or a potential trade, that’s the first sign. Stress will push you into the region of ‘unreason’, and you’ll be more susceptible to making a bad, impulse decision.
If you think you might be at risk of making an impulse trade, ask yourself these questions:
Do you feel that you are rushing to get into a trade in case you ‘miss’ it?
Are you basing whether to take this trade or not on a prior trade, either missing that trade or it being a loss?
Do you feel sick or nervous just before, or just after you’ve entered a trade?
Have you focused on making a good trading decision, that is, are you following your trading methodology?
If the answer is ‘yes’ to the first three questions, and ‘no’ to the last question, then you are very likely making an impulse trade.
As in all trading psychology problems, there is one solution – don’t panic. Of course, quelling panic isn’t easy. Remember that panic comes when a fixation causes a situation to seem direr than it actually is.
The best way to avoid panic and indecision is to always trade based upon a proven trading plan which clearly defines the conditions by which you enter and exit the market, and perhaps more importantly, how much of your capital you are going to risk on each trade.
Any sense of disappointment which comes with a losing trade is therefore the result of adverse conditions in the market for the traders trading system – not the trader. When this is the case, you should not ascribe self-blame and create a massive trading psychology complex.
You have to remember that not all trades will win and that when you lose money using a proven system, you shouldn’t panic. When you’ve lost money on an unstructured, impulse trade however, it is time to start looking at your trading psychology mindset.
In both cases stay away from panic or it will control your next move.
Trading Psychology is a key part of out Workshops. We’ll teach you the common pitfalls which catch out novice traders and give you the mindset to take your trading to the next level.
Article Source: EzineArticles