What You Need to Know About Loss Aversion & Trading 3
Another example of loss aversion causing us to act against ourselves is when it prevents us from crystallizing losses when our positions turn against us.
Returning to our hypothetical trader and his position in Apple, loss aversion creeps into his decision making process when he has to decide whether or not to close out his position after it turns against him.
3. Loss Aversion
Having gone long at $145 and seeing the share price run just a few cents shy of his price target, Apple fell down into the mid $142 level, leaving him nursing a loss. At this juncture, he has to decide whether or not to hold on to his shares and wait/hope for price to rally, or take his losses and exit.
The logical approach would be for him to decide at what level he needs to exit the position, and from there calculate a risk-reward ratio based on his already determined price target of $149.98. If the ratio is in his favor, then holding on to his shares and waiting to see what happens is a logical thing to do.
If the ratio is not in his favor, then the opposite needs to be done – close the position and exit the trade. (Note that he really needed to calculate the risk reward ratio as well as the stop loss level before putting on the trade)
However, this simple decision is complicated by loss aversion.
Since closing out the position would make his losses real while simultaneously ending any hope of him being able to make money on the trade, his mind will be screaming at him not to do it.
This in turn exposes him to even more losses if prices continue to fall. Should this occur, and he allows the loss to snowball even further, he runs the risk of bankrupting his account!
Loss aversion, if left unchecked, has the power to dominate our thought processes and cause traders to lose money. Firstly by not taking potentially profitable trades, and secondly by causing small losses to snowball into massive ones.
The effects of this bias are insidious to any trader’s PnL, and as such needs to be actively guarded against. An effective way to do this is to maintain the discipline of calculating reward/risk ratios for every potential trade, and logging these ratios in a trading journal.
When this is done, a trader can get a good idea of how the potential profit of each trade stacks up against the risk that must be taken to achieve those profits. This in turn allows traders to quickly and easily compare the relative merits of different trades.
This process should imbue traders with some degree of confidence in their decision making process. Which can help ensure that trading decisions are made based on the relative merits of risk and reward together, instead of purely focusing on the potential of losing money.
Ultimately, the discipline of this process, when practiced repeatedly over long periods of time, can help all of us to better guard our decisions against our natural human aversion to loss.
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