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Disposition effect

Trading consistency is a common struggle among newbie traders in the Forex Industry. The reasons are similar and it's lack of actionable education, psychology, money/trade management and no defined edge. I want to touch specifically on the disposition effect which has a lot to do with psychology and a good starting point for traders entering the market.

Has there been times when a position goes against you, but you're reluctant to admit your wrong? How about that feeling when you close out in profit too soon? You have 100% experienced the disposition effect! You hold losers and close winners!

How did disposition effect come about?

Hersh Shefrin and Meir Statman were pioneers in economics and behavior finance. The two incorporated work from Amos Tversky & Daniel Khaneman who were extremely intelligent psychologist. By combing psychology, Shefrin & Statman were able to understand human emotions in the financial world. In 1985, a eye opening paper called, "The Disposition to Sell Winners too Early and Ride Losers too Long", was released.

The paper states that traders are reluctant to realize their loss, which end up turning into bigger losers. On the winning side, traders end up selling an asset to soon to lock in gains. This is similar to a theory called, prospect theory. Prospect theory explains how humans react to different alternatives of risk/uncertainty.

This completely goes against what trading is about. In trading, you need to let your winners run and cut your losses when you are wrong. For a trader, it can be hard to let a winning position ride out. Especially after a period of draw down, you just want to capture any profit you can.

The Fix

If you have strong bias in the market,hopefully fundamentally, you should have more of an incentive to let a position ride out. This is different than being greedy and wanting more. Its about knowing that a certain catalyst still has more potential in your assumed direction. Part of this requires having a strategy where you know profit targets along with market structure.

A big piece of the puzzle will be understanding and being aware of your psychology. When you are in a position, you need to fight bad human habits and detach yourself from fear off loss & hope trading. Fight the urge to close a winning position too early, and hoping a losing trade will turn around. The more you gain experience, the more you will learn trading is psychology.

Posted 
December 18, 2019
 in 
Trader Toolkit

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