Professor Mark Fenton-O’Creevy of the Open University is a recognized authority on the role emotions play in financial decisions.
Trading is inherently emotional, and expert traders learn to manage these emotions effectively. They are less prone to extremes, viewing the outcomes of individual trades within the broader context of a year or an entire career. These traders develop strategies to avoid emotional traps—a process that requires years of intense practice.
Spread betting amplifies emotional stakes due to the leverage involved, which magnifies both gains and losses. Private investors often need strategies that acknowledge strong emotions while ensuring these emotions do not derail their trading plans. For instance, using stop losses can provide a pre-planned exit strategy, preventing the emotional urge to hold onto a losing trade in the hope of recovery. However, even experienced traders can be tempted to move a stop loss when emotions take over.
Short-Term vs Long-Term Trading: Emotional Dynamics
Short-term trading demands rapid decision-making, making it difficult to rely on rational thought over instinctive reactions. This highlights the importance of rehearsing market scenarios and planning responses in advance. Conversely, longer-term trading allows for more reflection but requires emotional resilience to withstand market fluctuations over time. It is critical to trade at levels that maintain emotional comfort, as panic-driven reactions to losses can lead to poor decisions.
Alick Mighall, managing director of a Brighton-based technology company, highlights the importance of maintaining emotional discipline, stating that he would only use money he is prepared to lose. He sees potential in spread betting but approaches it cautiously, especially for short-term trading.
Penny Booth, a retired teacher from High Wycombe, finds short-term trading emotionally demanding but appreciates the simplicity and potential for quick gains. She prefers the straightforwardness of betting on indices, seeing it as a way to manage risks without extensive analysis of individual stocks.
Nick Austin, director of a transport company based in St Austell, enjoys the challenge of short-term trading, particularly in volatile markets. However, he acknowledges the emotional toll it can take and prefers strategies that allow for quick decisions without excessive complexity.
Alick says he would be keen to use stop losses. These can provide a mechanism not just for protecting you from adverse market movements but also a useful pre-planned exit strategy to protect you from the natural emotional reaction to a loss; staying in the trade in the hope the loss will reverse. Even so it is common to see a trader, caught up in the emotions of a losing trade, move a stop loss as the price approaches it.
Penny, Alick and Nick have all given some thought to long versus short term trading. These have different emotional dynamics. Short-term trading requires rapid decision-making and makes it hard to avoid emotional decisions. The faster you have to think the harder it is to rely on your relatively slow rational processes as opposed to the more rapid ‘intuitive’ mode. This places a premium on having rehearsed possible market scenarios and appropriate responses beforehand.
Longer-term approaches provide the opportunity for more considered reflection, but emotions are by no means absent. It is one thing to have a view about the risk you are prepared to carry in exchange for a given level of return, but you also have to sleep at night. It is important to trade at levels where you can maintain a level of emotional comfort or you risk unwise panicked reactions to market movements.
The Impact of Volatility
Volatility can drive emotional reactions to markets – one US volatility index (the VIX) is known as the ‘fear index’, perhaps with justification. In one study we wired up professional traders with heart sensors and found that in volatile markets they had much greater difficulty managing their emotions. If this is true of professional traders it is doubly so for less experienced private traders putting their own funds at risk.
Penny expresses interest in the potential for using shorting to profit in volatile markets and Nick reasonably points out that volatile markets can provide opportunities for profit that are not there when markets are more stable. This is certainly true, although the reverse also applies – the downside risks are greater. Whilst volatile markets do present opportunities they raise the emotional stakes. This can distort decisions. When combined with the leverage built into spread-betting this can be a emotionally potent combination.
Trading in volatile markets requires strategies for emotion management as well as risk management. There is some overlap between the two; both place a premium on pre-planned explicit trading strategies and the use of stop losses. However it is also important to understand your own risk tolerance and emotional resilience and set yourself trading limits which keep you in your emotional tolerance zone.
Penny Booth expresses interest in the opportunities presented by volatile markets but admits that the emotional stakes can be daunting. Nick Austin, on the other hand, sees volatility as an opportunity for profit, particularly when combined with short-term trading strategies. Alick Mighall remains wary of volatility but appreciates the potential for gains with the right risk management tools.
Alick’s view that shorting feels more like gambling is interesting since there is no reason to believe he would have different success rates predicting the fall than the rise in an asset price. However, it may be the unfamiliarity of this mode of trading which is heightening his awareness of the gambling element inherent in any trading. There is certainly evidence on the reverse effect, in familiar but stressful situations people are often prone to illusions of control; the tendency to believe you have greater control in a situation than is realistic. Top traders emphasise the importance of rigorous honesty with themselves and our research has shown traders who suffer illusions of control to perform less well.
So volatile markets amplify emotions. This reinforces the need for strategies to manage emotions as well as risks; and honesty and self discipline in facing the market risks. As one senior trader told me in response to my question about essential trader attributes “Two words – ‘self-honesty’ and ‘discipline’ “.
Shorting and Hedging: Strategies for Risk Mitigation
If you have a portfolio of shares, unit trusts and other investments, spread betting can be a useful additional tool, especially in uncertain times when markets are volatile.
As most of us know, you can use spread betting to make profits in falling markets by betting that a particular share or index will drop in price. This is something that it is effectively impossible to do when buying shares in the traditional way, through a broker, and is one of the major advantages of spread betting.
‘Short selling’, ‘shorting’ or ‘going short’ as this simple but powerful technique is known can be used to offset losses in your portfolio by hedging against risk.
Hedging is the practice of making an investment to protect against the risk of another investment and traders often use spread betting in this way.
Let’s suppose that you have a significant holding in the shares of a particular company and you believe that its prospects are good and you are happy to hold the shares for the long term. However, you believe that its next set of annual results, due in a couple of months, are likely to be poor and that the price will fall in the short term as a result.
You could sell your shares now, put the money in the bank and buy them back more cheaply once the price has fallen. If you did this though, on top of the hassle involved, you would have to pay stamp duty at 0.5% plus two lots of dealing commission, once when you bought and once when you sold again. On top of that, you could be liable for capital gains tax on the profit you made from selling the shares.
On top of that, if the shares rose instead of falling, you might end up substantially out of pocket on the deal.
Instead, you could use spread betting to hedge your portfolio. Rather than sell the shares, you place a short bet on the company’s shares, betting that it will fall over the next couple of months.
If you are right, and the company’s share price drops when its annual results are released, you close the bet and take your profits, offsetting the losses suffered on the shares themselves. There are no dealing charges to pay on spread betting and your gains are tax free.
You can also hedge against rising prices. Let’s say you plan to buy a block of shares in a company in six months time, when you receive your annual bonus at work, but you are worried that the share price will increase in the mean time, so you won’t be able to afford to buy as many shares. You could borrow money now to buy the shares and pay off the loan when you get your bonus, but this is likely to be expensive and could go badly wrong if the share price fell instead of rising.
Instead, you could use spread betting to bet that the price will go up over six months and add the profits to your bonus so that you could afford more shares.
Alick Mighall, managing director of a Brighton-based technology company.
Hedging is something that I’ve done in other areas and I can definitely see the point of it. If I got involved in spread betting for the long term, I would definitely be thinking about doing this.
Penny Booth, a retired teacher from High Wycombe
While shorting definitely appeals as a way of seeking opportunities in difficult markets, hedging is too complex for me. You’ve go to go into a lot of detail about your investments and that doesn’t really appeal to me. I can see that it might work for some people but it is not for me.
Nick Austin, director of a transport company, based in St Austell.
Shorting absolutely makes sense to me as part of a trading strategy but I can’t do hedging. I just don’t like the complexity of it – I prefer things to be straightforward and simple.
Mark Fenton-O’Creevy: Inside the Mind of the Spread Better
In his best-selling book, “Thinking Fast and Slow”, Dan Kahneman makes the point that, because “thinking is hard”, we rely on mental shortcuts. Both Penny and Nick resist the idea of hedging because they feel it is too difficult. Yet hedging is an important risk management tool and risk management should be a central concern for any spread better. Alick is more open-minded about hedging and sees it as potentially a useful tool in any long term trades.
It is because thinking is hard that humans have developed mathematical systems and machines to do some of our thinking for us. So we do have tools to help us. However, sometimes an unwillingness to think too hard about risk management can arise from an unconscious desire to avoid thinking about risks and exposure to the negative emotions the risks arouse. This can be even more harmful than the ways in which intense emotions shape our decisions. This avoidance of negative emotions may underlie some of the denial of risk indulged in by senior bankers in the lead-in to the recent worldwide financial crisis.
Another feature of hedging, of course, is that in exchange for limiting risks it reduces potential profits. There are no free lunches in financial markets. Unwillingness to hedge can also be driven by unrealistic ambitions about the scale of returns that are possible in a market. Combined with an emotional aversion to confronting market risks this is a dangerous combination.
One of the more important characteristics of the top traders we looked at in our research was this capacity to face up to risks and to make realistic appraisals of opportunities within carefully managed risk limits. This self-discipline was also reinforced by the role of managers in allocating and policing risk limits and in monitoring and hedging aggregate trading positions where appropriate. For the private investor lacking such management support, the challenge of understanding and managing risks is greater.
There are twin and opposite dangers; the first, that the emotional reaction to careful consideration of market risks leads to inability to trade; the fear factor gets in the way of ‘pulling the trigger’. The second danger is that the emotional reaction to market risks drives a tendency to downplay or ignore risks; resulting in trading with no clear risk-management strategy and greater downside risk than you are really willing to bear.
This is Part 1 of a two part series on Mastering Emotions in Trading. Part 2 can be found here: Mark Fenton-O’Creevy: The Emotional Rollercoaster of Trading
