Are You Losing Money Trading To This Sneaky Bias? 2
The disposition effect significantly reduces our ability to trade out of large losses, which is what makes it so insidious – it allows us to dig ourselves into a hole that we later cannot get out of.
How then can we ensure that we do not fall prey to it?
5. Disposition Effect
The first step is to recognize that the market is signaling something when a position is profitable or nursing a loss.
This means that, if a trade is profitable, the market is signaling that there is a decent chance of it continuing to be profitable. Likewise, if a trade is losing money, the market is saying that it will probably continue to lose money.
Why is this the case?
Simply because markets tend to move in three general ways – trending up, trending down, or moving within a range (a.k.a sideways or whipsaw markets).
This means that if you enter a position that is aligned with the market’s trend, for e.g. going long in a bull market, the probability of your trade making money is much higher than if you do not.
Consequently, going long in a market that is trending up will see your position generate profits relatively quickly, and can be construed as a signal that more profits are possible.
On the other hand, if you were to enter a position opposite to the trend, for instance going short in a bull market, there is a high probability that your trade will end up with a loss.
Trades which quickly fall into the red can be thought of as a sign that the position isn’t aligned with how the market is trending, and that heavier losses are a possibility.
However, these signals aren’t as effective when a market is trading in a range, simply because when a market is range bound, profits can quickly turn into losses, and vice versa.
Therefore, if you are trading with the trend, the market will quickly give you feedback on whether or not the trade will work out in the near future.
As such, the best way to sidestep the disposition effect is to do what the market is telling you to do: stay in profitable positions, and exit unprofitable ones.
It is important to note that trading according to a market’s trend is not a substitute for rigorous risk management.
Consider a scenario where you went long in a bull market, but instead of quickly reaping gains, the trade instead rapidly racks up losses. In this situation, it is possible that you entered at an inopportune time; just before a correction, or just before the market topped out.
Since market timing is unpredictable at best, stop losses and sensible position sizing are still necessary to ensure that loss making positions do not act in concert with your cognitive biases to wipe out your trading account.
That being said, how can we allow our winners to run to their full potential while still effectively managing risk?
To be concluded…
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