In this Marketpulse article we’re going to investigate the concept of ‘good trades’ and ‘bad trades’. We’ll note that good trades are a result of making ‘good trading decisions’ but alas may still have ‘bad outcomes’. Conversely, bad trades are a result of making ‘bad trading decisions’ and on occasion may actually result in ‘good outcomes’. The trader’s best weapon in breaking the mould of most novices who lose wads of cash in the market is to focus only on making good trades, and worrying less about good or bad outcomes.
In our Live Data Trading Workshop we attempt to deliver students trading strategies which help identify the best trades to suit particular and personal trading specifications. We have a number of trading strategies which can be used to reap rewards from the stock market, with each strategy using a particular structure or ‘setup’ to formulate a smart trade. Most traders however don’t have such a structure, and as a result, too often succumb to the dreaded ‘impulse trade’. This is a largely overlooked concept in trading literature and refers to an unstructured, non-method, or non-setup trade.
Succumbing to Spontaneity
We’ve all been there!
You look at a chart, suddenly see the price move in one direction or the other, or the charts might form a short-term pattern, and we jump in before considering risk/return, other open positions, or a number of the other key factors we need to think about before entering a trade. Other times, it can feel like we place the trade on automatic pilot. You might even find yourself staring at a newly opened position thinking “Did I just place that trade?”
All of these terms can be summed up in one form of trade – the impulse trade.
Impulse trades are bad trades because they are executed without proper analysis or method. Successful traders have a particular trading method or style which serves them well, and the impulse trade is one which is done outside of this usual method. It is a bad trading decision which causes a bad trade.
But why would a trader suddenly and spontaneously break their tried-and-true trading formula with an impulse trade? Surely this doesn’t happen too often? Well, unfortunately such trades occur all the time – even though these trades fly in the face of reason and learned trading behaviours.
Even the most experienced traders have succumbed to the impulse trade, so if you’ve done it yourself don’t feel too bad!
How it Happens
If it makes no sense, why do traders succumb to the impulse trade? As is usual with most bad trading decisions, there’s quite a bit of complex psychology behind it.
In a nutshell, traders often succumb to the impulse trade when they’ve been holding onto bad trades for too long, hoping against all reason that things will ‘come good’. The situation is exacerbated when a trader knowingly – indeed, willingly – places an impulse trade, and then has to deal with additional baggage when it incurs a loss.
One of the first psychological factors at play in the impulse trade is, unsurprisingly, risk. Contrary to popular belief, risk is not necessarily a bad thing. Risk is simply an unavoidable part of playing the markets: there is always risk involved in trades – even the best structured trades. However, in smart trading, a structure is in place prior to a trade to accommodate risk. That is, risk is factored into the setup so the risk of loss is accepted as a percentage of expected outcomes. When a loss occurs in these situations, it is not because of a bad/impulse trade, nor a trading psychology problem – but simply the result of adverse market conditions for the trading system.
Impulse trades, on the other hand, occur when risk isn’t factored into the trading decision.
Risk and Fear
The psychology behind taking an impulse trade is simple: the trader takes a risk because they are driven by fear. There is always fear of losing money when one trades the market. The difference between a good trader and a bad trader is that the former is able to manage their fears and reduce their risk.
An impulse trade occurs when the trader abandons risk because they’re afraid of missing out on what looks like a particularly ‘winning’ trade. This impulse emotion often causes the trader to break with their usual formula and throw their money into the market in the hope of ‘not missing out on a potential win’. However, the impulse trade is never a smart one – it’s a bad one.
If the trader identifies a potential opportunity and spontaneously decides they must have the trade – and then calms down and uses good strategy to implement the trade – then this is no longer an impulse trade. However, it the trader disregards a set-up trigger or any form of method in making the trade, they’ve thrown caution to the wind and have implemented a bad trade.
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Result of the Impulse Trade
Impulse trades typically end in one of three ways:
Alternative 1: The ill-conceived impulse trade results in a loss (odds-on outcome!)
Alternative 2: The impulse trade results in a loss, but subsequently becomes the trigger of a valid setup. The trader ignores the setup for the sake of their previous loss and misses out on the next win.
Alternative 3: The impulse trade that actually wins. Occasionally an impulse trade will work out in the trader’s favour. This is sheer luck!
From another viewpoint, however, a winning impulse trade is bad luck because it reinforces the taking of a bad trade simply due to a good outcome. One winning impulse trade will spur on more impulse trades and under the right market conditions some of these may also have good outcomes. It’s a natural tendency for traders to focus on winning outcomes – regardless of the quality of the decisions which caused them.
This is a particularly dangerous situation for traders as all of their negative trading traits (which would usually cause losses in normal market conditions) are being reinforced. As one would expect however, more often than not, bad trades made from bad trading decisions will result in losses. When the market eventually ‘rights itself’ and the aberration which allowed some bad trades to have good outcomes disappears, the trader is left confused as to what constitutes a successful approach, and is undoubtedly nursing big losses.
The trader has failed to focus on the quality of the trading decision, but rather than the quality of the outcome. In this way the impulse trade is little more than gambling, because gambling is based on pure chance whereas good trading is based on calculation and reason. There is risk inherent in both trading and gambling, but in the former, risk is accommodated and is simply an expected outcome in an overall proven winning strategy.
One must remember at all times that trading psychology is an incredibly important part of setting up a winning trading career. If one doesn’t remain calm, a few winning impulse trades are going to be outweighed by the eventual losing impulse trades, and cause a whole bundle of trading psychology issues down the track.
Curing the Impulse Trade Urge
So, how does a trader know that they’re at risk of an impulse trade, i.e. how does one stop the problem before it develops?
We’ll answer this question in next week’s Marketpulse so stay tuned!
Trading Psychology is a key part of our Live Data Trading Workshops. We’ll teach you the common pitfalls which catch out novice traders and give you the mindset to take your trading to the next level.
Head of Education