Mark Fenton-O’Creevy on Trading Psychology: Betting on Indices
This is Part 2: Part 1 can be found here: Mastering Emotions in Trading: Professor Mark Fenton-O’Creevy
Company share prices can be affected by a range of factors, to do with the company itself, the industry it operates in and the wider economy. While many private investors enjoy researching companies to understand their prospects, others find it complex and daunting.
Spread betting provides traders with the option of betting on stock market indices such as the FTSE 100 and the Dow Jones. This is something that is impossible to do with traditional brokers.
Betting on indices allows traders to take a view of broad economic trends, which can be easier to research and understand. It is also a way of exploiting international opportunities without the complexity and uncertainty of buying shares on overseas stock exchanges.
There are many different market indices, covering individual countries, regions, sizes of company and industries. In Britain, the FTSE 100, which covers the country’s leading 100 shares, is the best known but there are several others, including the FTSE All-Share, the FTSE 250 (which covers 250 medium-sized firms), the techMARK 100 (corr) which covers technology-based businesses and the FTSE AIM All-Share Index of smaller companies.
As well as the familiar Dow Jones Industrial Average, the United States has over fifty other indices, covering companies of different sizes and operating in different industries. Dozens of other countries, from Argentina to Zimbabwe, have their own indices, as do regions such as Asia, Europe and Latin America. Popular ones include the Dax 30, which covers Germany’s biggest companies, the French CAC 40 and the Nikkei 225 of Japan’s leading stocks.
If you’re considering betting on indices, it’s important that you understand what your chosen index covers and what factors might cause it to move in one direction or the other.
Betting on an index is exactly the same as betting on an individual share. You choose the index that you are interested in and bet on it to rise or fall, by pressing the ‘Buy’ or ‘Sell’ button, depending on your view of its prospects. As with other forms of spread betting, there are no dealing charges and your profits are free of tax.
If you are contemplating betting on indices, it is important to be aware of the risks involved. Indices can be volatile and can move sharply and unpredictably in response to economic news or market sentiment. Falls and rises of several hundred points over a day are far from unknown so the potential for losses can be great.
For this reason it is extremely important to set stop losses when spread betting. This means specifying a lower limit to the index on which you are betting (or an upper limit if you are going short). Once that point is reached the bet is automatically closed, limiting your potential losses.You can set a stop loss very simply at the moment you place your bet.
Alick Mighall, managing director of a Brighton-based technology company.
This quite appeals to me and it seems like a reliable way of making money. I think you could fairly accurately call market prices in any given day. Also, although the idea of shorting shares doesn’t sit easily with me, I’d be quite comfortable with shorting an index. If I was going to try spread betting, this is what I’d go to first.
Penny Booth, a retired teacher from High Wycombe
I like to take a macroeconomic and global view of things so the ability to trade on indices definitely appeals. At the moment the only way I can track an index is through a specific fund but I would prefer to do it through spread betting as it is easier to manage my risk.
Nick Austin, director of a transport company, based in St Austell.
I find the idea of trading on indices very appealing because they can be quite volatile and present very good opportunities for profits. They tend to have high volumes of trading because people are drawn to them as investment opportunities.
Mark Fenton-O’Creevy: Inside the Mind of the Spread Better
Have you ever seen the shapes of animals or faces in the clouds? This tendency to look for recognisable patterns in the world around us is a fundamental aspect of human psychology. It is often useful, because it makes us sensitive to patterns in our environment, important for our survival or success. Often we cue into patterns via emotional reactions before we have a conscious cognitive awareness of them. We talk about having a hunch or ‘gut feel’. Experienced traders talk about developing a ‘feel for markets’. There is some evidence that, via a combination of this ‘feel for a market’, analysis and some degree of privileged information on demand and supply patterns, expert professional traders can do a bit better than random at anticipating market moves.
However, just as we can see faces in clouds that are not really there, we are easily fooled by randomness in financial markets. Alick’s assertion that he could ‘accurately call market prices in any given day’ is much more likely to be an example of being fooled by randomness, of spotting faces in the clouds, than a real product of expertise and privileged information.
Penny ‘likes to take a macroeconomic view’, this ‘fundamentals’ approach implies a longer trading time-horizon, whereas Nick’s attraction to the possibilities he sees for profit in the volatility of index prices, implies a shorter term focus. Each faces different challenges. The intra-day volatility, that Nick is interested in, offers risks as well as opportunities. Seeking profits from short term price movements can be something of an emotional roller coaster and demands an intensity of focus and short-term emotional resilience. The advantage is that you can close out positions at the end of the day and set the market out of your mind. The longer investment time horizon implied by an interest in economic fundamentals allows for a more leisurely pace in analysing markets and making trading decisions. However, it also typically implies a need for trading positions which persist for lengthy periods. This can make it hard to separate psychologically from your trading position and requires a different kind of emotional resilience. The kind that allows you to sleep well even when your trade is not performing as you hoped and to dispassionately exit from a trade you have engaged with over a lengthy period; accepting a necessary loss, rather than breach the risk limits you have set yourself.
Foreign Currency Trading
Many traders feel that they would like to deal in shares listed on stock exchanges in other countries. This can be attractive if the market in another country appears to be doing well, or if you have particular knowledge of a company or industry that operates in other countries. It is also a way of building up a geographically diverse portfolio, which can help to insulate your investments against an economic downturn in a particular country or region.
For the very committed investor, trading on foreign markets can simply be a way of extending the trading day beyond UK hours, allowing you to deal on markets in the evenings or overnight, for example.
However, dealers may be put off by the currency risk that can be inherent in trading on foreign markets. When you buy and sell shares in other markets, you have to take account of movements in the value of the currency of the country in which you are dealing, as this can significantly affect the profit or loss that you ultimately make.
If you bought 1,000 shares in a French company for 5 euros each and sold them in three months time for 5.2 euros, you would make £182 profit, if the pound was worth 1.1 euros when you bought and sold. But if the pound had gone to 1.2 euros at the moment when you sold, you profit would be wiped out and replaced with a loss of £212, because the euro profit that you made from the sale would buy you fewer pounds.
So when dealing in shares on foreign markets, you not only need to consider the prospects of the share itself, but you also need to take a view of what is going to happen to the local currency against the pound.
With spread betting all your deals are conducted in sterling. You can buy shares quoted on the US Dow Jones, the French CAC or the Japanese Nikkei and the entire transaction takes place in pounds so there is no need to worry about changes in the exchange rate.
However, if you are interested in the opportunities presented by fluctuations in the exchange rate, it is possible to place a bet on how you think one currency is going to perform against another.
So if you think that the pound is set to perform well against the US dollar, you can buy sterling against the dollar, in exactly the same way as you might buy a company share. If you are tempted by this sort of trading, you should bear in mind that currencies can be extremely volatile and prices can change very rapidly. As with other forms of spread betting, it is extremely important that you set a stop loss. This means specifying a lower limit to the index on which you are betting. Once that point is reached the bet is automatically closed, limiting your potential losses. You can set a stop loss very simply at the moment you place your bet.
Alick Mighall, managing director of a Brighton-based technology company.
This doesn’t particularly appeal to me, even though you do reduce the risk of having to change in and out of currencies. You’d still be thinking about what might happen if the pound moved sharply during a trade.
Penny Booth, a retired teacher from High Wycombe
This is really appealing because dealing in foreign shares is so complex because you have to factor in exchange rates to all your trades. Not having to worry about exchange rates would make dealing in foreign shares much easier.
Nick Austin, director of a transport company, based in St Austell.
Yes, this is a big attraction for traders considering investing in foreign shares. I can completely see the advantages of doing this, especially if you’re investing for the long term.
Mark Fenton-O’Creevy: Inside the Mind of the Spread Better
Alick is concerned about the complexity introduced by currency risk whilst Penny and Nick see the potential for a spread-bet hedge to take some of the complexity out of trading shares denominated in other currencies. Human psychology tends to push us toward simple models of the way the world works and simple models and ideas can be very powerful but can also be powerfully misleading. Einstein was pointing to this when he said “Everything should be as simple as it can be; but not simpler”.
This issue is at the heart of what research has begun to teach us about the nature of expertise. Expertise is not the application of simple models and heuristics. Simple rules and models are more a feature of the thinking of novices. Experts tend to have highly complex mental representations of their world and to recognise situation on the basis of deep experience. This expertise takes a significant time to build up and comes though applying significant effort and critical attention to practicing key skills. The ability to deal with complexity is vital to traders but is built up though this process of deliberate practice. It is possible to practice until hedging currency (and other) risks becomes second nature. For example, by putting time and effort into trading a virtual portfolio and then a small proportion of your risk capital; taking on increasing levels of complexity
For those willing to put the time and effort into grappling with a little complexity, there are good reasons to believe that currency spread bets can be a useful tool for managing risk. However, the combination of a desire for simplicity and the human tendency to see patterns in randomness means that many novice traders are drawn to making simple bets on currency market movements. Simple trading in the currency markets is a zero sum game; for every winner there is a loser and the average return is less than zero. The large majority of currency trading is carried out by large banks with better information, lower transaction costs, and greater expertise than any novice.
Any trader should be concerned with developing the expertise to deal with the real complexities of trading. This requires critical thinking and a good deal of reflective practice. In the end it is also these which are the best defence against being the prey in the complex ecology of financial markets.
The Psychology of Spread Betting: Doubling Up
Many investors who hold share portfolios find that spread betting can be an extremely useful tool and a means of quickly and easily capitalising on a high-performing stock.
If you believe that one of the shares in your portfolio is about to go up in value, your natural instinct is to increase your holding of that share. You might want to do this only for a short period because you believe, for example that it is set to rise on a positive set of results.
Your natural instinct might be to go into the market and buy more of the share in question. However, this assumes that you have the cash spare to do so. You would also have to pay dealing charges when you buy – and, ultimately, when you sell – as well as stamp duty.
Let’s say that you had invested £10,000 in Vistry Group PLC shares in April 2024, when the price stood at 650p. By late July the price had risen to 700p and you might have wanted to buy another 1,000 shares.
To buy these from a broker in the traditional way you would need to find the full £7,000 purchase price as well as pay dealing charges and stamp duty.
By the end of 2024, the price had risen to 850p and your profit would have been £1,500 minus the dealing charges and stamp duty.
If instead of buying the shares in July, you had decided to place a spread bet on Vistry Group PLC shares, you would have bought at 751p at ￡15.30 (including the spread) and then sold at 849p.
You would have made a profit of 98 points from the trade, and at ￡15.30 pounds per point that is a profit of ￡1499.40, on which you would pay no dealing charges or stamp duty.
Alick Mighall, managing director of a Brighton-based technology company.
I can see the sense in doing this but personally, if I was convinced that a particular share was going to go up in value, I would only use money that I had and was prepared to lose.
Penny Booth, a retired teacher from High Wycombe
I would definitely do this. It seems like a great way of taking advantage of a rising stock without having to lay down large amounts of money for it. I could see myself using spread betting for this from time to time.
Nick Austin, director of a transport company, based in St Austell.
Although my preference in investments is to put down money up front, I could imagine circumstances in which I’d do this – for example if I saw the opportunity for easy pickings on a particular stock.
Mark Fenton-O’Creevy: Inside the Mind of the Spread Better
Alick, Penny and Nick have rather different reactions to the idea of using spread-betting to ‘double-up’ on existing investments for a period. Penny is the most positive, clearly seeing the advantages of low transaction costs and avoiding the need to find liquid funds for the whole value of the asset. This perhaps reflects her previously stated appetite for risk. Nick is less certain but sees circumstances in which he might take this approach. Alick too, can see some possibilities but makes the very important point that he would only commit money he was prepared to lose. This is important because, the most effective way of managing your emotions when trading is to avoid speculating with money you can’t afford to lose.
There are two primary problems that poor emotion management can create. The first is inability to execute a planned trading strategy; being derailed by strong emotions while trading, or becoming too fearful to ‘pull the trigger’. The second is more insidious, it is avoiding emotions by ignoring or downplaying risks. This desire to avoid negative emotions can also lead to making a false distinction between ‘paper losses’ and realised losses; telling yourself that it is not really a loss until you exit the trade.
Good traders develop strategies to manage their emotions which do not involve either suppressing them or ignoring information likely to make them anxious. In our research we often heard top professional traders talk about the importance of self-honesty and discipline; so how do professional traders keep themselves honest? Many follow a practice of ‘writing things down’. For each trading session they write down their trading strategy and only change it if they have first written down the reasons for doing so. This acts as a commitment mechanism and prevents rewriting history. Further, the act of writing down reasons for any change often forces a realisation that the reasons are either insufficient or driven by fear or greed.
Many traders have also developed the capacity to ‘reframe’ the emotional meaning of large losses or gains; reminding themselves that every trader loses and that some gains come from foolish decisions. There are other ways of reframing. For example, when you are considering exiting a trade to limit a loss or realise a gain, imagine yourself starting with a clean slate and consider whether you would buy in at this price.
The Psychology of Spread Betting: Managing Emotions and Risks
Over the last six weeks I have taken a look at the psychology of spread betting, and looked at the biases and emotional traps traders are prone to.
A fundamental difference between spread-betting and buying and selling shares and other assets is the leverage involved. This leverage tends to amplify the emotions that accompany trading gains and losses. Properly managed, our emotions can be beneficial to effective decision-making. They enable rapid responses when we recognise an unfolding situation; they help us discriminate between different elements of the flood of information facing us at any one time. However emotions can also badly mislead. Many investors describe the problems they have in sticking to a planned trading strategy when overwhelmed by emotions. A common problem is the inability to accept a loss and move on. Traders often take increased, even foolish risks in order to try and ‘win back’ a loss.
Risk perceptions, too, can be a casualty of strong emotion. Humans are, quite naturally, motivated to avoid strong negative emotions. Some do this by escaping into self-protective illusions. We easily fool ourselves that we have more control than is reasonably possible, or ignore information about risks.
Penny is the most enthusiastic about spread-betting and keen to set aside a fixed sum of money and ‘play’ with spread betting. Nick is a fan too; seeing most potential in short term bets but rather sceptical about shorting or hedging. Alick sees spread betting as another potential tool in his armoury. All three seem mostly interested in the potential of spread betting to enable them to take simple short term directional bets on price movements. Alick goes so far as to say “I think that based on what you learn from following markets around the world it would be possible to make fairly good forecasts of price movements, especially within a limited time”. His confidence is almost certainly misplaced. Even highly experienced traders with access to good information have poor success rates in predicting price movements.
Spread-betting can offer very useful tools for risk-management as part of a portfolio of trading activity, this includes the use of shorting, and currency trades as ways of hedging risks elsewhere in a portfolio. Hedging risks does add in some complexity to trading. However there is another reason why some traders dislike hedging. In exchange for limiting risks, hedging reduces potential profits. Unwillingness to hedge can be driven by unrealistic ambitions about the returns that are possible in a market. Emotional reactions may also foster a tendency to downplay risks, to avoid the negative emotion that thinking about risks invokes. The result can be trading with greater downside risk than you are really willing to bear.
Finally, as we have seen, an important part of developing expertise as a trader is learning to manage your emotional responses effectively. This can be supported by developing good habits such as writing down trading strategies and writing down any reasons for changing them.
Spread betting amplifies the emotional aspects of trading due to leverage. While emotions can aid decision-making by highlighting critical information, they can also mislead, particularly when traders become overconfident or overly fearful. Strategies for managing these emotions include:
- Developing clear trading plans and writing them down.
- Using stop losses to manage risk.
- Practicing self-honesty and discipline.
- Reframing emotional responses to losses or gains to maintain perspective.
Effective risk management, including tools like hedging and stop losses, is essential for successful trading. While complexity can be intimidating, building expertise through deliberate practice and critical thinking is the best defense against the psychological pitfalls of financial markets. By combining emotional regulation with robust risk management, traders can navigate the challenges of spread betting with greater confidence and success.
