Trading is emotional for most of its participants. Your own emotions added to the emotional side of the market will largely determine whether you will end up a trading day as a radiant winner or whether you will leave the market as a downcast loser. Not in vain, there is the following saying among experienced traders, “buy fear, sell greed”. This article is designed to explain initially why a discussion about emotions is essential to success in long-term trading and to show you later how to conquer the poisonous cocktail of fear and greed as well as how to use it to your own advantage.
Both academic and non-academic work on stock market price action has multiplied in recent decades. Many of these trials quickly show an overview of the basic problem we are going to address. However, they fail to provide you with the tools you need to succeed every day on the market. Therefore, I will only show you here an incomplete outline of the results of this research. This incursion into theory will clearly reveal the weaknesses of some of them and, at the same time, will answer the question of why the psychological-emotional part of market analysis is so important. Moreover, this market approach can be of great help to you.
Weaknesses in the Efficient Market Scenario
First, mention should be made of the fact that the two poles of investigation of the market efficiency hypothesis and behavioural finance have been more or less at odds for decades. Despite the fact that the efficient market hypothesis was created by Eugene F. Fama in the 1970s, it has since contributed significantly to describing markets and prices through simple models, making them more transparent. In short, this assumption assumes that markets will be efficient when markets reflect all available information. However, trading costs, as well as any existing information asymmetries between different groups of market participants, are not taken into account. Particularly questionable is the postulation of the hypothesis in its strict form, which indicates that the success of the investment of professional participants is more a random process. However, many traders who have been successful for decades have shown that the opposite is true.
Only behavioral finance can provide a plausible explanation for extreme volatility.
For a long time, markets were dominated by the efficient market scenario. However, as illustrated in Figure 2, the 1980s were characterized by an extreme increase in stock volatility, which was obviously impossible to explain by means of Fame theory. We had reached a point where it no longer made sense to look at markets without including human emotions. Therefore, the theoretical design of behavioral finance is equivalent to a revolution and rupture of a taboo, making the ivory towers of academic dogma tremble. Suddenly, the psychological variables of human behavior were especially those that had to be taken into account in such a way that the behavioral finance center was the main cause of the formation of bubbles in prices and the appearance of periods of high volatility. Since the limited rationality of market participants means that adaptation strategies, called “heuristics”, have had to be used in decision-making, information acquisition – to name just one example – may increase the cost incurred by market participants. Each operator is familiar with it, as it is part of their daily operation: When things get lively in the markets, they tend to look at prices more often.
When Emotions Become a Problem
You want to maintain some control over the market in which you operate. But in turn, it wastes time, creates unnecessary stress, and, if you are not careful, can even lead you to an impulsive operation. But if you have put the stop loss, and stick to your risk management, you don’t have to worry as you don’t control the market anyway. The real benefit of heuristics, the decision-making for saving resources, weakens, and in the worst case, deviates from the right path. You may act compulsively just because the market has again moved a few points against you. Despite your determination to comply with your negotiation strategy, you find yourself acting too quickly and drawing biased conclusions caused mainly by your emotional perception. For example, you have been able to decide that you want to make a profit on the operation you have open and give you “a little more leeway”. Novice traders often follow this process of increasing the stop-loss distance.
However, this behavior can completely undo even a sophisticated risk management strategy and significantly reduce your trading capital. Therefore behavioral finance comes with a statement that is diametrically opposed to the efficient market hypothesis: Because of the many incentives, the behavior of market participants, and the allocation of capital, financial markets are not efficient. Both suffer from information costs and psychological constraints. Each trader, whether private or institutional, knows from their own experience that decisions about individual trades are often made based on rules. The basic problem is that these decisions can be ‘colored’ emotionally.
Emotions also obscure the fundamental value.
Until recently the debate in the academic literature has been dominated by so-called “limits of arbitration” of mental construction. This implies that the fundamental price of an asset is of vital importance. Therefore, irrational price deviations are only allowed for a limited period of time due to arbitrage (risk-free profit) by rational investors. However, so-called “noise traders” do not look at the core values of a stock. They buy and sell in such large quantities that rational investors have difficulty closing the gap between fundamental rational value and actual market price. What matters here is the sheer power of the market. If you are aware of it you will be able to protect yourself according to the motto: The market is always right.
Rational Versus Irrational Behaviour
So far this article has focused on describing why dealing with the world of emotions is of vital importance in trading. Attempts have also been made to illustrate how emotions can put their results at serious risk. Now, however, we will move from the grey world of theory to the real world of everyday practice. How to transform past knowledge into operational success?
To this end, decision-making between rational and irrational behaviour must be optimized. As a trader, you should primarily learn how to quickly decide which ìtone’ is displayed by market participants; that is, whether in certain phases emotional behavior is more rational, or more irrational. That is the decision making in the outside world that can be explained very well with specific examples of trading.
Decision-making in the “Inner World”
A little more difficult, but essential to success in trading is the way to a correct interpretation of your own emotions. Especially in discretionary trading, emotions can never be ruled out. Anyone who says otherwise is denying human nature. So you have to learn to have companions of your emotions that you listen to carefully and keep in check the impulsive need to operate as your imagination will be conducting a riot. The first and most important rule is: In any situation, stay calm and don’t panic. True, that sounds easier than it looks in reality. Emotions have a powerful impact and will suggest you change your behavior. Now, how will you achieve the specific level of inner peace that is needed to operate successfully?
Don’t take pressure on yourself: Are you nervous about your friends and colleagues telling you stories of your countless successes? So it is adding an additional pressure to itself that it does not have to bear. If you fail in your trading, you can rest assured that you will be greatly affected and criticized. Instead, trade only for yourself. Look at it as a game you can’t win if you’re completely relaxed or with your knees completely straight. The optimal state of mind must be between fear and greed, which is also called “respect for the market”.
Pay attention to your diet: dairy products contain catalase, table salt is a chloride, and wheat products contain gluten. Taking these substances will change your digestion from aerobic to anaerobic, while activating a number of hormones in your body. Do you have the feeling of not obeying yourself? Maybe it’s because your hands are tied by your diet. It’s not a good omen for success in trading that, among other things, has a lot to do with reconciling yourself with your emotions. Try to lead a Spartan life for three months. Your health and trading account will thank you. Institutional traders are supported by entire risk departments. As a private trader, you operate on your own and what you need to succeed is to keep your head clear.
Analyze yourself: the traumas of the past tend to turn against you in troubled times and markets are the perfect breeding ground for it. Make an agreement with them, otherwise, they will show up again and sabotage your trade. This process will take years to complete. The stock market is an expensive location to investigate who you are. Therefore, use the time during which you do not operate to work yourself. It will be cheaper for you. Meditation and yoga can really do wonders.
Stay calm and don’t let others run your life: Not everyone needs to know what you do to live or earn extra income. In human relationships, many things happen subtly causing emotions that are a nuisance. Someone says something stupid and you’re thinking, “Wait and see, I’ll prove it to you”. In this business, you have to have thick skin. In most cases, getting angry involves making the mistakes of others. Don’t get carried away and don’t do impulsive operations.
Enjoy something enjoyable: Consumption financed by the benefits of trading will reinforce your positive feelings. These in turn will manifest in the neural circuits of the brain. Then you will begin to think like a winner.
Decision-Making in the Outside World
Now that we have seen how you can get a better view through the “inner world” of your emotions, let us open ourselves to the outer world. For traders, it is worth looking at the picture from the outside, for example, to analyze the “greed and fear index” reported by CNN Money which can also be used in intersectoral analysis. This indicator is based on seven sub-indicators with equal weighting among which is the VIX (CBOE volatility index), which is a typical measure of fear and momentum of the S&P 500.
This index is shown with values below the 25-point line which indicates a growing fear among securities operators. On the contrary, securities above 75 points are a sign of increased greed in stock markets. Its peak in 2007 was a good indicator that warned traders in time against the crash and also generated a good investment signal in 2009. However, it reached another peak in Q1/2012 generating a false long-term selling signal.
It is not the Holy Grail but it is useful when combined with filters.
After the above, we deduce that this isolated indicator has limited validity. But however, combined with filters such as market profiles or economic data, quite reasonable results are achieved. For example, the use of market profiles allows you to see well that novice operators operate in areas where prices are very low in volume. It is because their operations are often determined by fear. Only after the professionals have cashed out, the novels will overcome their fear and get in the car. Often, by then, it will be too late.
The situation makes one thing clear: A market sentiment that is characterized either by extreme fear or extreme greed deserves the trader’s attention. Often when everyone is afraid it is worth entering. However, keep in mind that a good investment sign combined with various counter-trend techniques is the best insurance against bad surprises. In the long run, markets will only move along the macroeconomic pathways. Therefore, a change of trend in the markets is always preceded by a very important development of the economy.
Unfortunately, what happens very often at the really relevant trading points are abrupt moves. Several hundred points in a day are not uncommon. But, obviously, you must also bear in mind that trends are long-lasting. This is where, statistically speaking, value will be rewarded in most cases, as long as volume is still important.
Most neophyte traders don’t see market action as what it really is, that is, a brutal business. What can you really do now to use the phases of greed and fear for your own benefit? A good preparation: Treat each operation with utmost care because a good preparation is the best way to deal with emotions. In professional trading, any real trade has been preceded by many hours of research. In particular, unconventional news sources such as the Project-Syndicate.org or ZeroHedge.com are good early indicators. The moment the stock market lets you see where you’re going, it’s usually too late. So make sure you devote at least eight to ten hours a week to studying the national and international press.
Working a scenario: Are you an intuitive operator? So much better, in that case, what you need is to regularly feed your intuition. Every second, the human brain is bombarded with 600-900 million bits of information. Most are processed unconsciously and largely determine their behavior through the decision-making process. All this is illustrated in Figure 5. Trading in the stock market is like a game of chess. It is necessary to create a scenario based on the information provided. Those who prepare their scenarios will see their operations in a much more relaxed way and will be free from fear and greed. If the scenario that we have prepared is not given, so much the better. In that case, we will use the loss stop and rethink the situation.
Never beat too much: As a trader, sometimes there will be too much risk in the market. Your initial greed will make you experience a feeling of discomfort that will worsen second by second before it finally turns into sheer terror. ¡ That fear is justified! You just over-leveraged your account and now you can inflict a lot of damage on it at any time. Among other things, the line between gambling and trading is determined by leverage.
Put loss stops: Do you often operate in the market without using loss stops? We must have the courage to do this because in the fast markets legitimate fears will be triggered.
Do not operate too much: Operate when you are mentally well prepared. If you operate the same way you play in a video game, your subconscious will be absolutely thrilled but the stock market will soon teach you a very tough lesson.
How you deal with your emotions will be the key to your success or failure in the stock market. Have the time to work yourself. Profitable trading is not a closed book, but the result of hard work applying a good strategy, with reasonable assumptions and, above all, control in itself. Only when these three factors interact properly will you be consistent with what happens and thus be able to succeed, such that you will catapult your trading to a new dimension. Keep it up and remember: never be too serious, never too informal – in the middle is just what works best.