Explain the emotional and psychological reasons why some traders fail to close out losing positions before their losses spiral out of control
Emotional and psychological reasons have contributed to the failure of some traders. Confirmation bias is one of the behaviors that has contributed to this failure. As such traders tend to seek information that supports their current opinion and disregard the information that refutes their beliefs. Individuals filters out potential useful facts in investment which affects decision making in investment as trader make less than optimal choices, and at the end, they are not able to close on losing positions especially if the refuted information turns to be useful.
There are a lot of fluctuations in the financial market ranging from prices of stock. Traders always fail to learn from past experiences on the market especially the terrible moments which could have helped them to make the better judgment. Individuals always focus on the current situation ignoring the past experiences, and when some of these past problems re-occur, some of the traders are not able to mitigate the consequences due to ignorance. Investors tend to add much to the current situation only because the market has moved in their anticipated direction instead of making decisions based on past experiences.
This is a mistaken belief that if something occurs regularly during a period of time, the likelihood of it happening in future is less. For instance, newbie traders can choose high leverage from the beginning after other traders has experienced low returns sometimes back. In their mind, they assume that some factors that contributed to low returns on other investors will not happen anytime soon (London Academy of trading n.d).
Describe the emotional and psychological reasons why traders holding winning positions tend to close out these trades too early before the price reaches their targets.
Sometimes, traders feel the tensions, emotions, and desire to close their winning trades earlier even before the prices reaches their goals. Some psychological and emotional behaviors has contributed to this trend. For example, some traders have hard instinct; a mentality characterized by the absence of decision-making that makes individuals act same as others. In finance, traders might close the winning position and shift their investment based on the fact that other investors have turned their attention to that direction (London Academy of trading n.d). Another behavior is herding which causes investors to sell off their shares based on apparently less vital evidence to validate. Herd instinct causes bubbles in finance that are characterized by rapid growth of asset prices followed by contraction. Lastly, there is sucker rally which is a temporary rise in a specific that cannot be justified positive vital information to back the movement in price. Traders are forced to close their trades as the result of sucker rally is fall in prices of prices on the market or particular falls (London Academy of trading n.d).
Outline the techniques and processes that traders can employ to avoid falling victim to the emotional and psychological biases explained above
Traders are required to know his/her trading strategy to the last possible detail. It is not enough to familiarize with strategy, rather, they should have a complete awareness of what signals from the market. Traders should establish a trading plan that comprises of a mass knowledge of the area, attending trading seminars and enrolling in online courses (Willis,2008). Everybody should spend much his/her time studying changes in prices, read interviews with a policy maker, managers, and financial experts. Traders should implement a strict risk management plan. Most traders give their emotions a chance to escalate if they fail their strict rule to manage every security. Therefore, they should risk only the amount which they feel convenient in case they lose to protect themselves against the chance of becoming a highly emotional traders. Also, there is no need for the trader to trade too much and should abstain from overtrading. Trading too much leaves traders more exposed to financial risk as some of them end up becoming emotional (Baker & Ricciardi, 2014).
Explain the different situations that traders may experience which may cause them to become overconfident
The illusion of knowledge
The illusion of knowledge is the tendency of traders to overestimate their ability to influence routes that they have little control. Nowadays, investors are bombed with information that motivates some them to regular changes to their portfolios to master the environment. However, this information might not be reliable and do not help the traders to make better forecasting. Notably, many traders lack enough skills and training to interpret the information.
The Illusion of Control
Traders become overconfident when they feel that they have control on their achievement in their investment yet this may not be the case. The illusion is common in familiar situations and in circumstances where investors are aware of the desired outcome. Some factors, namely, active involvement, availability of information, task familiarity and choice has contributed to the illusion of control. When there is a great amount of information, traders have greater illusion. Also, some of the traders have been in business for long, and hence they feel control over their investment (London Academy of Trading n.d).
Describe how this overconfidence can cause a trader to change their behavior, often resulting in poor trading performance
Overconfidence causes traders to misinterpret the available accurate information and then overestimate their capability and this results in the poor investment decision. Also, overconfidence has led to gender inequality when it comes to trading. Men tend to be more overconfident as compared to women in trading and investment hence ends up frequently trading as compared to women. Overconfidence has further led to increased trading which is dangerous to profitability. For instance, studies have shown that when male invest, they perform worse as compared to women. Since the men have invested more, the market is not that profitability. Also, there is a high level of commission and slippage in high turnover hence trading must be subtracted. Overconfidence has an effect on risk-taking behavior. Traders invest in many portfolios to get more return while concentrating less risk that might be encountered. In fact, some of the investors do not know on how to interpret the level risks that take (London Academy of Trading n.d).
Outline the techniques and processes that traders can employ to avoid falling victim to overconfidence when trading
The first technique is to invest more and trade less. Traders should understand that the investment environment is broad and they are trading against experts from all over the world with more experience and more data. The odds are overpoweringly in their favor. Traders should increase their time frame to mirror indexes and take advantage of dividends, and they will be successful. Traders should depend on existing market data to make various decisions on investment and focus less on the experience they have. A trader should realize that they are vulnerable to consequences as a result of decisions they make. It is therefore recommended that investors should involve themselves in various investment forums to hear other investors ideas (Armenia, 2013)
Armenia, G. (2013). Lazy Thinking: How Cognitive Easing Affects the Decision Making Process of Business Professionals.
London Academy of Trading (n.d), Behavior and Trading Psychology
Baker, H. K., & Ricciardi, V. (2014). How biases affect investor behavior. Retrieved from http://www.europeanfinancialreview.com/?p=512
Willis, L. E. (2008). Against financial-literacy education. Iowa L. Rev., 94, 197
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