Understanding your emotional reactions and how they color your trading decisions is important because most trading mistakes are made when traders act on their emotions.

This is easily observed through the disposition effect, where traders sell out of profitable positions too early, and hold on to losing positions for too long. 

While this sounds like, and is, a foolish thing to do, traders do it all the time! Inexperienced traders are especially susceptible to it, even though when they first read about it they may scoff and think that they won’t ever do such a thing.

Why is this the case?

Simply because reading about trading doesn’t involve our emotions, but actually trading does.

When a position goes in our favor and starts making money, we feel afraid that those profits will disappear if the market turns against us, causing us to feel like closing out the position; not just to keep hold of whatever profits we’ve made, but also in order to stop feeling afraid.

On the other hand, when we are losing money on a position, we tend to hold on to them in the hope that the market will turn in our favor, allowing us to at least break even on the position.

Making matters worse is the fact that trading is a dynamic exercise, meaning that our emotions change as the market changes.

Should we hold on to a losing position and be fortunate enough for the market to move back in our favor, getting us back to even, we are then faced with a new decision, and hence a new emotional reality.

Having told ourselves that we would exit a losing position if it gets back to even, and actually exiting if it gets back to even are two completely different states of mind.

Why?

Because when the position gets back to even, greed starts to kick in and we begin to think: “if the market already moved in my favor and turned a losing position into a winning one, who’s to say that it won’t keep going in my favor?”

Consequently, we may end up continuing to hold on to the position simply based on how market fluctuations are making us feel.

Considering that markets fluctuate all the time and never move in a straight line, it is easy to see that allowing our emotions to dictate our trading decisions is not an effective strategy, and will at some point lead to financial disaster.

To be continued….