How to Manage Fear and Greed in Trading
- Reviewed by James Stanley, Nov. 24, 2021
MANAGING FEAR AND GREED WHILE TRADING: MAIN TALKING POINTS
- Fear and greed are two drivers that influence our everyday lives
- These influences carry over to trading and can be detrimental
- Traders can remove these drivers by looking at the big picture and planning ahead
Fear and greed are often identified as the main drivers of financial markets. This is clearly an oversimplification, however fear and greed do play an important role in the psychology of trading. Understanding when to embrace or tame these emotions could prove to be the difference between a successful trade and a short-lived trading career.
Keep reading to learn more about fear and greed in trading, including when these emotions are likely to surface and how best to manage them.
THE TRUTH ABOUT FEAR AND GREED WHILE TRADING
‘Fear and greed’ can be commonplace among traders and can be rather damaging if not managed properly. Fear is often observed as the reluctance to enter a trade or the closing of a winning trade prematurely. Greed on the other hand manifests when traders add more capital to winning trades or over-leverage with the aim to profit from small moves in the market.
There are numerous traces of the origins of these two drivers, but when analyzed logically greed and fear both stem from the innate human instinct of survival.
What is fear?
We know that fear is somewhat related to the fight-or-flight instinct that exists in each and every one of us. It is what we feel when we recognize a threat. Traders experience fear when positions move against them as this poses a threat to the trading account.
Watching a position move against you invokes the fear of realizing that loss and so traders tend to hold on to losing positions for much longer than they should. In fact, this was discovered as the number one mistake traders make when DailyFX researched over 30 million live trades to unearth the Traits of Successful Traders.
A second scenario where fear tends to get the better of traders is right before entering the market. Despite the analysis pointing towards a strong entry, traders may find themselves bogged down by the fear of loss and end up walking away from a well thought out trade.
Fear is often present when markets have crashed and traders are reluctant to buy at the bottom. In this scenario traders often decide not to enter a trade out of fear that the market will drop further and miss out on the rise higher.
What is greed?
Greed is very different to fear but can easily land traders in as much hardship if not managed appropriately. It tends to arise when a trader decides to take advantage of a winning trade by devoting more money to the same trade, in the hope that the market will continue to move in the trader’s favor.
Greed can also surface when traders experience a losing trade and decide to ‘double down’, in the hope that throwing more money at the problem will help the position turn positive. From a risk management point of view this is very risky if the market continues to move against the trader and can quickly turn into a margin call.
Greed has appeared many times in the financial markets. one such time was during the dot-com bubble where individuals bought more and more internet stocks and inflated their value tremendously before it all came crashing down. A more recent example is bitcoin; investors piled into the cryptocurrency thinking it could only increase in value before it too came crashing down.
Learn more about major financial bubbles, crises and flash crashes.
HOW TO MANAGE GREED AND FEAR TO BE A SUCCESSFUL TRADER
There are several ways to take control of your emotions and make sure fear and greed do not influence your trading decisions or overall success.
1) Have a Trading Plan
Traders should have a trading plan in place to avoid any emotional impulses that deviate from the plan. Some examples of this include: overleveraging, removing stops on losing positions, doubling down on losing positions.
2) Lower Trade Sizes
“One of the easiest ways to decrease the emotional effect of your trades is to lower your trade size” – James Stanley, DFX Currency Strategist
This was one of the many good points made in our article focusing on managing the emotions of trading.
Furthermore, the article continues to state that placing a large trade on a demo account will not result in any lost sleep, as there is no actual financial risk. However, traders will most certainly experience stress after witnessing price swings on a large live trade. Such stress has the potential to lead to bad decisions which may impact the trading account negatively, so it is crucial to keep these in check.
3) Keep a Trading Journal
Traders also need to be accountable to themselves when trading. The best way to do this is to create a trading journal. Trading journals assist traders to record their trades and make note of what is working and rectify strategies that aren’t. Its important to remove all emotion when evaluating the results of your trades and cut unsuccessful strategies.
If you’re a currency trader, read our guide to keeping a forex trading journal.
4) Learn From Others
At DailyFX we set out to discover what had worked for traders in the past so that others may be able to benefit from those traits in the future. The result of this is the Traits of Successful Traders research.
This research shows that emotion plays a significant part in trading, as it was found that on average, traders lost money even though there were more winning trades than losing trades. This was because the losing trades outweighed winning trades i.e. traders stood to lose more when the market went against them than they would receive if the market moved in the traders’ direction.
Traders can look to tackle fear and greed in trading by instituting the thesis from this research, stated by David Rodriguez as:
‘Traders are right more than 50% of the time but lose more money on losing trades than they win on winning trades. Traders should use stops and limits to enforce risk/reward ratio of 1:1 or higher.’
FURTHER READING ON THE PSYCHOLOGY OF TRADING
- Keeping emotions in check is essential to successful trading. Find out how to manage the emotions of trading.
- Traders will often target a certain number of pips per day as a psychological goal. Discover what mindset traders should be using.
- Keep a trading journal to stay on track with your personal strategy.
- Confidence is a huge part of trading – read our guide on how to build confidence in trading.
By Richard Snow, Analyst, 6th December 2021. DailyFX
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