Asymmetric Loss Aversion
One aspect that back-testing doesn’t account for is what’s called “asymmetric loss aversion” which is another way of saying that losing hurts more than winning feels good. This often has an adverse affect on beginning traders following a losing trade, or multiple losing trades, because for most people losing is stressful and it’s harder to maintain focus under stress. This loss of focus will often lead to mental and physical mistakes and even to the trader “throwing in the towel” on a trade, or a position, rather than sticking to the method and seeing the results through.
This can be a problem for both longer-term position traders and day traders. A trade can have a positive net result, but if at some point over the course of being in the trade a draw-down was experienced, the stress the trader felt may effect his willingness to take the next trade. In other words even a winning trade may not feel like a winning trade, which points out the importance of separating “feelings” from market reality. “Market reality” being that regardles of the efficiency of the method, if you do not execute it properly, regardless of both account drawdowns and intra-trade drawdowns, you’re wasting your time and money. The only way to get over the fear of losing money is to continue demo trading until you are convinced the method is sound, and worth the risks involved. And to have a trading plan that spells out ahead of time how you are going to react or NOT react to adverse price movement. The more you practice it the more you will see that it takes less and less nerve to stick to your trading plan. In trading there is no way around the risk. The more you try to eliminate it, the closer you become to being a demo lifer.
Understanding ahead of time that you will feel stress and fear when a position goes against you, which is routine in trading, should strengthen your resolve to sticking to your trading plan.
For more info on a similair subject see: http://trading-u.com/blog/index.php/archives/441
Jay Norris
www.trading-u.com
DISCLAIMER: Futures, options and Forex (off-exchange foreign currency futures and options, or “FX”) trading involves substantial risk of loss and is not suitable for every investor. The valuation of futures, options and Forex may fluctuate, and, as a result, clients may lose more than their original investment.
Great article. Stress cannot be totally avoided. We are not machines…
But demo trading to know the method and knowing that some stress is part of the game, sure helps control it in normal levels.
Also feeling too happy, even euphoric after a winning trade can have bad consequences – over confidence that can lead to hasty positions.