in Stock Futures and Options Magazine
by: Price Headley
dictionary defines fear as "an unpleasant, often strong emotion
caused by anticipation or awareness of danger, going on to explain
that fear...implies anxiety and usually the loss of courage."
This definition of fear is useful in helping define the issues that
traders face when coping with fear. The reality is that all traders
feel fear at some level, but the key is how we prepare to address our
concerns related to taking on risk as a trader. In this article I will
review four major fears experienced by traders, and I'll take it a
step further by noting how the outcomes of these fears create
undesirable trading behaviors. Basically, my aim is to have you walk
away with an understanding of these dangers so you can and implement
strategies that will address your fears and let you get on with your
Mark Douglas, an expert in trading psychology, noted in his book,
Trading in the Zone, that most investors believe they know what is
going to happen next. This causes traders to put too much weight on
the outcome of the current trade, while not assessing their
performance as "a probability game" that they are playing
over time. This manifests itself in investors getting too high and too
low and causes them to react emotionally, with excessive fear or greed
after a series of losses or wins.
As the importance of an individual trade increases in the trader's
mind, the fear level tends to increase as well. A trader becomes more
hesitant and cautious, seeking to avoid a mistake. The risk of choking
under pressure increases as the trader feels the pressure build.
All traders have fear, but winning traders manage their fear while
losers are controlled by it. When faced with a potentially dangerous
situation, the instinctive tendency is to revert to the "fight or
flight" response. We can either prepare to do battle against the
perceived threat, or we can flee from this danger. When an investor
interprets a state of arousal negatively as fear or stress,
performance is likely to be impaired. A trader will tend to "freeze."
In contrast, when a trader feels the surge of adrenaline but
interprets this as excitement or a state of greater alertness before
placing a trade, then performance will tend to improve. Many great
live performers talk of feeling butterflies just before they go on
stage, and how they interpret this as a wake-up call to go out and
perform at their highest level. That's clearly a more empowering
response than someone who might interpret these butterflies as a
reason to run back to his dressing room to get sick! Winners take
positive action in spite of their fears.
1. Fear of Loss
Analysis Paralysis and Its Cousins
The fear of losing when making a trade often has several consequences.
Fear of loss tends to make a trader hesitant to execute his trading
plan. This can often lead to an inability to pull the trigger on new
entries as well as on new exits. As a trader, you know that you need
to be decisive in taking action when your approach dictates a new
entry or exit, so when fear of loss holds you back from taking action,
you also lose confidence in your ability to execute your trading plan.
This causes a lack of trust in your method or, more importantly, in
your own ability to execute future trades.
Thus, you can see how fear can set in place a vicious cycle of
recurring doubt and, in turn, reinforce a traders' lack of confidence
in executing new positions. For example, if you doubt you will
actually be able to exit your position when your method tells you to
get the heck out, then as a self-preservation mechanism you will also
choose not to get into new trades. Thus begins the analysis paralysis,
where you are merely looking at new trades but not getting the proper
reinforcement to pull the trigger. In fact, the reinforcement is
negative and actually pulls you away from making a move.
Looking deeper at why a trader cannot pull the trigger, I believe the
root stems from a lack of confidence about the trading plan, which
then causes the trader to believe that by not trading, he is moving
away from potential pain as opposed to moving toward future gain. No
one likes losses, but the reality is, of course, that even the best
professionals will lose. The key is that they will lose much less,
which allows them to remain in the game both financially and
psychologically. The longer you can remain in the trading game with a
sound method, the more likely you will start to experience a better
run of trades that will take you out of any temporary trading slumps.
When you're having trouble pulling the trigger, realize that you are
worrying too much about results and are not focused on your execution
process. Make sure your have a written plan and then practice
executing your plan.
Start with paper trades if you prefer, or consider trading smaller
positions to get the fear of losing out of your system and get
yourself focused on execution. When in the heat of battle and
realizing you need to get in or out of a trade, consider using market
orders, especially on the exit. That way you can't beat yourself up
for not pulling the trigger on your trade.
Many traders may get too cute with a trade and try to work out of a
position at a limit price better than the current market price, hoping
they can squeeze more out of a trade. But as famed trader Jesse
Livermore advised in the classic book Reminiscences of a Stock
Operator by Edwin Lefevre, "give up trying to catch the last eighth."
Keep it simple with a market order to exit allows you to bring closure
when you need it, which reinforces the confidence-building feelings
that come from following your trading plan. In the past when my
indicators noted it was time to exit, I have experienced firsthand the
pain of not getting filled at my limit, watching the option drop and
then placing a new limit back where I should have exited at the market
in the first place! Then I have realized I was not going to get filled
there either, so I again kept lowering my limit until, in frustration,
I placed a market order to exit much lower than I could have closed
the position initially. Not only can you feel the pain of loss
financially but, more important, you can chip away at your internal
state of confidence and create frustration by not getting filled.
You should be more concerned about avoiding big losses and less
concerned about taking small losses. If you can't bear to take a small
loss, you will never give yourself an opportunity to be around when a
big winning idea comes along, as every trade you enter has the risk of
first turning against you for a loss. You must execute by knowing what
your risk is in each trade, and define parameters to make sure you can
ride favorable trends correctly as well so that your winners will be
larger than you losers. And never get stuck in the mindset of hoping a
loser will come back to "breakeven," as that is one of the
trader's most deadly mental fantasies. Billions of dollars have been
lost by technology investors hoping their stocks would bounce back in
recent years to allow them to escape the downtrend. That only led to
even greater losses in most cases. That's how a short-term trader can
become a long-term investor unintentionally, and that is a position in
which you never want to put yourself.
Ask how well you trust yourself to execute your trading plan. You want
to judge your effectiveness based on how well you get in and out of
the market when your method gives entry and exit signals. You'll need
to be decisive, not hesitant, know in your heart that your method is
well tested and that your risk is low compared to your likely reward.
In other words, you must be fully prepared before you go into the heat
of battle during a trading day. You need to know where you will enter
and where you will exit if you are a discretionary trader. Or you need
to know what system you are following and be prepared to enter and
exit as the system dictates. This keeps you disciplined and focused on
following a process that can generate favorable results over time.
2. Fear of Missing Out
Being a Part of the Crowd Isn't
Everything It's Cracked Up to Be
Every trend always has its doubters, but I often notice that many
skeptics of a trend will slowly become converts due to the fear of
missing out on profits or the pain of losses in betting against that
trend. The fear of missing out can also be characterized as greed of a
sorts, for an investor is not acting based on some desire to own the
security - other than the fact that it is going up without him on
board. This fear is often fueled during runaway booms like the
technology bubble of the late-1990s, as investors heard their friends
talking about newfound riches. The fear of missing out came into play
for those who wanted to experience the same type of euphoria.
When you think about it, this is a very dangerous situation, as at
this stage investors tend essentially to say, "Get me in at any
price - I must participate in this hot trend!? The effect of the
fear of missing out is a blindness to any potential downside risk, as
it seems clear to the investor that there can only be gains ahead from
such a "promising" and "obviously beneficial"
trend. But there's nothing obvious about it.
We remember the stories of the Internet and how it would revolutionize
the way business was done. While the Internet has indeed had a
significant impact on our lives, the hype and frenzy for these stocks
ramped up supply of every possible technology stock that could be
brought public and created a situation where the incredibly high
expectations could not possibly be met in reality. It is expectation
gaps like this that often create serious risks for those who have
piled into a trend late, once it has been widely broadcast in the
media to all investors.
3. Fear of Letting a Profit Turn into a Loss
I get many more questions from subscribers asking if it is time to
take a profit than I do subscribers asking when they should take their
loss. This represents the fact that most traders do the opposite of
the "let profits run, cut losses short" motto: they instead
like to take quick profits while letting losers get out of control.
Why would a trader do this? Too many traders tend to equate their net
worth with their self-worth. They want to lock in a quick profit to
guarantee that they feel like a winner.
How should you take profits? Should you utilize a fixed target profit
objective, or should you only trail your stop on a winning trade until
the trend breaks?
Those who can accept more risk should consider trailing a stop on
their trending position, while more conservative traders may be more
comfortable taking profits at their target objective. There is another
alternative as well, which is to merge the two concepts by taking some
profits off the table while seeking to ride the trend with a trailing
stop on the remaining portion of the position.
When I trade options, I usually recommend taking half of the position
off at a double or more, and then following the half position still
open with a trailing stop. This allows you to have the opportunity to
ride my best trading ideas further, as these are the trades where I am
mostly likely to continue being right. Yet, I am also able to get the
initial capital at risk back in my pocket, which frees me from
worrying about letting a profit turn into a loss; I am guaranteed a
breakeven even if the other half position were to go to nothing
overnight. My general rule for the remaining half position is to exit
if it reaches my trailing stop of half its maximum profit on an
end-of-day closing basis, or scale out of the remaining half position
every time it doubles again.
I'm also a big fan of moving your stop up to breakeven relatively
quickly once the position starts to move in your favor, by about five
percent on a stock or by roughly 25 percent on the option. It is also
critical to recognize the impact of time spent waiting for a position
to move. If you are not losing but not yet winning after several
trading days, there are likely better opportunities elsewhere. This is
known as a "time stop," and it will get your capital out of
non-performers and free it up for fresher trading ideas.
4. Fear of Not Being Right - All Too Common
Too many traders care too much about being proven right in their
analysis on each trade, as opposed to looking at trading as a
probability game in which they will be both right and wrong on
individual trades. In other words, their overall method will create
The desire to focus on being right instead of making money is a
function of the individual's ego, and to be successful you must trade
without ego at all costs. Ego leads to equating the trader?s net worth
with his self-worth, which results in the desire to take winners too
quickly and sit on losers in often-misguided hopes of exiting at a
Trading results are often a mirror for where you are in your life. If
you feel any sort of conflict internally with making money or feel the
need to be perfect in everything you do, you will experience cognitive
dissonance as you trade. This means that your brain will be insisting
that you cannot exit a trade at a loss because it ruins your
self-image of perfection. Or if you grew up and feel guilty about
having money, your mind and ego will find a way to give up gains and
take losses in the markets. The ego's need to protect its version of
the self must be let go in order to rid ourselves of the potential for
If you have a perfectionist mentality when trading, you are really
setting yourself up for failure, because it is a given that you will
experience losses along the way in trading. Again, you have to think
of trading as a probability game. You can't be a perfectionist and
expect to be a great trader. If you cannot take a loss when it is
small because of the need to be perfect, then the loss will often
times grow to a much larger loss, causing further pain for the
perfectionist. The objective should be excellence in trading, not
In addition, you should strive for excellence over a sustained period,
as opposed to judging that each trade must be excellent. The great
traders make mistakes too, but they are able to keep the impact of
those mistakes small, while really riding their best ideas fully.
For the trader who is dealing with excessive ego challenges (yet, who
wants to admit it?), this is one of the strongest arguments for
mechanical systems, as you grade yourself not on whether your trade
analysis was right or wrong. Instead you judge yourself based on how
effectively you executed your system's entry and exit signals. This is
much easier for those traders who want to leave their egos at the door
when they start to trade. Additionally, because we are raised in a
highly competitive culture, the perception of a contest or competition
will also bring out your ego's desire to win and beat others.
You will be better off seeing trading as a series of opportunities
that will become apparent to you, and your task is to create a plan
that finds opportunities with potential rewards that are several times
greater than the risks you incur.
Be sure you are writing down your reasons for entering each trade, as
the ego will play tricks and come up with new reasons to hang on to
losing positions once the original reasons have evaporated. One of our
survival mechanisms is remembering the good and omitting the bad in
our minds, but this is dangerous in trading. You must acknowledge the
risk and use a stop on every trade to admit when the analysis is no
longer timely. This helps prevent undesirable situations where you get
stuck in a position because you did not adhere to your original stop.
This is a bad use of capital being tied up in an under-performing
position, when there are likely to be many better opportunities
elsewhere. Trading without stops is an ego-driven approach that hopes
to avoid accountability for a losing trading idea. This is an
unacceptable behavior to the successful trader, who knows he must
limit risk with stops to stay in the game for the next trading
In summary, your trading plan must account for the emotions you will
be prone to experience, particularly those related to managing fear.
As a trade, you must move from a fearful mindset to mental state of
confidence. You have to believe in your ability as well as the
effectiveness of your plan to take profits that are larger than the
manageable losses. This builds the confidence of knowing that you are
on the right track. It also makes it easier to continue to execute new
trades after a string of losing positions. Psychologically, that's the
critical point where many individuals will pull the plug, because they
are too reactive to emotions as opposed to the longer-term mechanics
of their plan. If you're not sure if you can make this leap, know that
you can if you start small.
Too many investors have an "all-or-none" mentality. They're
either going to get rich quick or blow out trying. You want to take
the opposite mentality - one that signals that you are in this
for the longer haul. This gives you "permission" to slowly
get comfortable and to keep refining your plan as you go. As you focus
on execution while managing fear, you realize that giving up is the
only way you can truly lose. You will win as you conquer the four
major fears, to gain confidence in your trading method and,
ultimately, you will gain even more confidence in yourself.