Characteristics Of The Markets

The unique world of trading stock, forex, commodity, etc.. is one that encourages traders to reject objectivity and logic in favor of the basic human emotions of greed, fear, hope and pride, with disastrous consequences. Let’s take a closer look at the markets and the psychological problems they create. Operating in an unstructured environment. Trading requires you to operate in an environment with few rules and little structure. Most people need order and rules for guidance, it is the way their lives have been structured since childhood. Man is brought up in a society that is held together by rules and laws that are imposed by an external authority.

Society is structured, and it is its definitive structure that makes people feel comfortable. Laws and rules are perceived as protection when our security and well being are threatened. We can, for instance, go to the police or Courts to look into and act on our grievances.

In contrast, the trading environment has no clearly defined rules and no structure. It would be, in society terms, total anarchy. The market moves where it wants, whenever it wants. The society of trading has no governing body that makes or enforces rules; there is no judicial body to appeal to should the investor feel prices are not moving in the right direction. This anarchy can be extremely unsettling for investors if they think prices should go up and they actually decline. There is absolutely nothing we can do about it. The market does not care whether investors make or lose money, it has no conscience, and it is a natural phenomenon and never has to justify its actions.

A harsh and hostile environment. Every trader tries to take money from everyone else. Everyone is trying to make money at everyone else’s expense. It is a uniquely harsh environment, everyone is against you and you are against everyone else. One analyst compares it to a medieval battle - a man used to go to the battleeld and hill his adversary while his opponent tried to do the same to him. The winner took the loser’s weapons, his chattels and sold his wife and children into slavery. Today traders to battle on the Exchanges instead of on the eld. When you take money away from a trader, it is not that different from drawing blood, he may loss his home, his chattels, and his wife and children may also suffer. Is this description a bit exaggerated? Perhaps; however, there is no denying how hostile the trading environment feels when you trade in it, to stand alone can be, and is, uncomfortable.

Confronting your inner self. Standing alone is uncomfortable because it makes people do one thing that most feel uneasy about, which is taking responsibility for one’s actions. Most people like to delegate responsibility, blame others and make excuses when they don’t succeed. Most people simply cannot face the simple truth that they are responsible totally for the consequences of their actions. A person can go for a job interview and convince himself that he did not get the job due to a personality clash with the interviewer. A lawyer can drink too much before an important case and convince himself he lost because the Jury was biased, a salesman can convince himself that it was his product that was not up to scratch and not his presentation.

The trader, however, has nowhere to hide when interacting with the market. He is really competing against himself, and the market will judge every day how well he is doing. This confrontation with our own personality, our strengths and weaknesses graphically exposes, is something most people would rather avoid.

The work ethic does not apply. The normal work ethic of time, effort and reward that is common in most job situations does not apply in the markets. For example, a factory worker putting in overtime and working extra hours is rewarded with more money. As a general rule, the greater the effort we put in, the greater the reward we expect. However, no such work ethic exists with the markets. A trader can spend years creating a trading system, only to see his equity wiped out in a matter of days. A trader, however, may quickly develop a simple system and reap huge prots. Whether we acknowledge it or not, we normally believe that we deserve money under certain conditions where we have to expend a certain amount of effort to get our reward. For example, an investor sitting on a big prot feels he does not deserve it, and therefore tries to snatch it. When a trader loses, he feels that his input in terms of effort means he deserves a reward and he holds his loss. His subconscious mind constantly equates time and effort with reward, and this affects his objective judgment.

There is unlimited prot and loss potential. This is the one characteristic that brings out the worst emotions in traders and causes them to lose. They simply cannot cope with the unlimitedness of the markets’ movements. This “unlimitedness” and the massive leverage available causes traders to create risk by their emotional desire to avoid it. This may sound illogical until we examine how an investor’s emotions interact with his perception of risk reward.

Consider the following: If making money is important to you, as it is to most people, you will have difficulty taking a small loss. If you bear in mind a trader’s self esteem and the fact that money is on the line, you will appreciate the psychological turmoil this can cause. Prots, on the other hand, are just as difcult to cope with. When a large prot occurs, he gets excited, and the bigger the prot becomes the harder it is to resist the temptation to take it now. However, prots need to be run to cover inevitable losses. In their efforts to avoid risk, investors actually end up creating it. Consider the following psychological test:

A group of people are given the following choice over a number of trades:

A 75% chance to win $1,000 with a 25% chance of getting nothing, or a sure $700. Four out of ve subjects take the second choice, even after it is explained to them that the rst choice leads to a $750 gain over time.

Another test gives people the following option; a sure loss of $700 or a 75% chance of losing 1,000 and a 25% chance of losing nothing. Three out of four took the second choice, condemning them to lose 50 more than they have to. So, in trying to avoid risk, investors create it.

Emotion causes most traders to act in a way that will lead to their ultimate demise. They prefer a sure gain, however small, to a logically based speculation to seek a large prot. On the other hand, they actually seek risk in the realms of losses. They let losses run to avoid taking a small loss and, by doing so, they create greater risk for themselves. They expose themselves to bigger losses when they could have had a certain small loss.