5. Disposition Effect

The trading aphorism of “let your winners run and cut your losers quickly” directly addresses the disposition effect; which is less obvious and more harmful than its cousins, loss aversion and the sunk cost effect.

The disposition effect is more insidious simply because going along with what it suggests doesn’t feel wrong.

Think about it: you put on a trade, it registers a small profit which makes you feel good about yourself, and decide to exit and take the profit.

What could possibly be wrong with locking in profits early? Isn’t that the whole point of trading anyway? There’s even an aphorism to back this up – “no one ever got hurt by taking profits”!

Unfortunately, there is something wrong about taking profits early, and that is the trade could potentially yield much higher gains.

Of course, no one knows in advance just how profitable a trade will turn out to be. This uncertainty is what creates the fear of losing whatever small profits have been accumulated over a short period of time.

If this sounds familiar, it’s because this fear is driven by loss aversion. As such, taking profits early out of fear of losing them is succumbing to loss aversion, which isn’t optimal behavior for traders.

Why?

Because should your trading account be hit with a big loss, small profits will not be sufficient to get your PnL back to even. It doesn’t matter whether or not the loss is a result of poor risk management, not effectively guarding against cognitive bias, or markets going crazy; small profits can’t cover large losses.

Which takes us to the other half of the disposition effect, the tendency to hold on to our losses.

This tendency is the result of the sunk cost effect acting in concert with loss aversion, and is what destroys the trading accounts of most new traders. Small losses are emotionally and psychologically difficult to take as our natural disposition is to want to give the trade some time, to see if the market swings in our favor.

The problem with this approach, however, is that when the small losses start to snowball, loss aversion and the sunk cost bias make it even more difficult to exit.

We start to think, “if I’ve already lost $10,000, what’s another $1,000?”, and decide to stick with the loss making trade.

When the loss becomes $20,000 we start to tell ourselves, “I’ll exit the position when the losses halve back to $10,000”. Of course, at this point, this has a low probability of happening as the market has quite decisively moved against the trade.

When we finally do decide to exit the trade, or our broker decides to force us to exit it, we are left nursing a large loss.

If the loss is $20,000, and we are in the habit of taking small profits of $200, that would mean 100 small winners will be needed to make up for that one massive loss!

To be continued…