What You Need to Know About Loss Aversion & Trading 2
How can loss aversion prevent us from taking profitable trades? Here’s an example that most traders can probably relate to.
3. Loss Aversion
Say for instance a trader is interested in taking a position in Facebook and assiduously follows how its stock trades over the course of six months. At the end of the period he has gained enough of an understanding of how the stock reacts to headlines, earnings and macro data to feel comfortable enough to put on his position.
Having seen FB make a bottom at $347.75, he decides to place an order with his broker that would get him long at $352. His rationale for doing so is that FB is trading in a strong uptrend, which makes $347.75 a possible area of support for a double bottom.
He chooses $352 as a possible future entry point to ensure that he can still enter the position even if the stock doesn’t fall all the way back down to $347.75.
Furthermore, he places a price target at FB’s previous high of $377.50, and intends to set his stop loss at $345. He does so to give the position some breathing room on the downside in case price falls below $347.75 (not making the double bottom), but catches a bid and rallies after.
With those levels, his trade has a reward/risk of ($377.5-$352) / ($352-$345) = 3.6; which means he stands to gain 3.6 times the amount he risks on the trade.
Finally, after working out his percentages, he decides that he’s comfortable risking $10,000 on the trade. This represents an amount that allows for substantial profit if the trade works out, but won’t take out a large chunk of his account’s equity if it doesn’t.
He has a good grasp of how FB is trading, has set predefined entry, exit, and stop levels in accordance with his risk management strategy, and has an excellent reward/risk ratio. It is, on paper, a great potential trade.
What could go wrong?
In a single word: execution.
When FB starts falling and moving closer towards his preferred entry point, instead of putting in the order to his broker in advance, he starts to have second thoughts.
What if the double bottom doesn’t materialize and FB’s price plummets below $345?
He would very quickly lose $10,000. While the amount isn’t a large chunk of his trading account, it still is a sizable amount of money to him.
Very quickly, his mind focuses on the potential $10,000 loss, instead of the reward/risk of 3.6.
He begins to think of all the things $10,000 can buy, the mortgage payments it can cover, the vacation he could go on. $10,000, in an absolute sense, is not a small sum of money for him to lose.
As his second guessing spirals into further doubt, he begins to question the soundness of his trading plan and decides to abandon the trade altogether – loss aversion dominates his psyche.
What happens after?
FB rallies strongly to hit his intended price target of $377.5 in just 7 trading days, and he can only sit, stare, and rue the what-could-have-been.
Of course, FB could just have easily plummeted past his stop at $345, in which case he would have felt justified in his decision to not put on the trade. However, in doing so, he succumbs to his outcome bias, instead of focusing on the fact that the optimal way to navigate trading uncertainty is by sticking to a well constructed trading plan.
Which he actually had before loss aversion clouded his judgment!
To be concluded…
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