Sunday, November 06, 2016

The Psychology of Trading Panic

Imagination can be a powerful creative force.  It's through imagination that we can see markets differently from the consensus, envisioning outcomes that are otherwise unforeseen.  When we see elevated put-call ratios and ongoing selling pressure in stocks, for instance, it can be useful to consider possible bullish outcomes that would lead to significant short covering.  Imagining scenarios that could lead to a non-consensus outcome can be powerful preparation for trading such opportunity.

Sometimes, however, our imagination runs wild and entertains the worst possible outcomes for our trades.  This is when the normal fear of loss can become panic.  When we panic, we respond to the threats--not the opportunities--generated by imagination.

Take a look at any intermediate-term market bottom.  The chances are good that you'll find very negative NYSE TICK numbers (a lot of sellers hitting bids) and elevated volumes on the selling.  Panic is part of what creates opportunities, as the selling of frightened traders creates opportunities for value investors.  An excellent post from The Mathematical Investor describes the folly of panic selling.  It is a major reason independent traders and investors typically fall short of returns generated by buy-and-hold.

One of the most common mistakes I see traders make is sizing positions too large for the amount of pain they are emotionally prepared to endure.  That creates a situation in which mere noise is likely to push a trader's panic button.  Traders love to tell themselves that they have a 3-to-1 reward to risk level in their trades and size their positions accordingly, not realizing that the odds of hitting the (artificial) downside barrier are quite high and (at their level of risk-taking) quite emotionally destabilizing.

A great exercise is to review your recent stop-outs and identify how many were rationally, proactively planned and how many were reactionary and panic-based.  It's one of the ironies of trading that successful traders plan for losses, while unsuccessful ones hope for gains.

Further Reading:  Overcoming Performance Anxiety in Trading