Human beings are hard wired to feel certain emotions. The vast majority of us experience fear and greed, especially during the trading and investing process. When we lose money we experience anxiety as trading accounts drop in value. When the losses mount, anxiety turns to fear as portfolio values drop below our comfort levels. If losses continue to mount, fear can turn into panic. Conversely, when our trades succeed, we want even more success. So we raise our expectations to unrealistic levels – the "greed" factor. However, if you get to know and understand these common emotions, you can learn how to react in a profitable way.
Boom and Bust
The fear and greed cycle is at the core of all boom and bust cycles. Too much of anything will usually provoke the opposite response as markets tend to revert to the mean - and often overcorrect as they adjust to find a new equilibrium. Therefore, as traders, we have to learn how to navigate through the volatile movements of the markets and to find a way to take advantage of the inefficiencies and opportunities that are presented as the markets gyrate between extremes of optimism and pessimism.
To do this we have to train ourselves to take the appropriate actions at the appropriate times in order to achieve successful trading results. (Curious about how emotions and biases affect the market? Find some useful insight in Taking A Chance On Behavioral Finance.)
What Is a Feedback Loop?
A feedback loop is a mental construct that transitions from a conscious action into a subconscious behavioral response. In a positive feedback loop, positive actions lead to positive results that reinforce positive actions, which, in turn, lead to more positive results.
For example you could make a well-researched investment decision that results in positive returns. Now you have more money and are less anxious about investing, so you make other clear decision with further positive results.
Negative Feedback Loops
There is a flip side, of course. Negative actions lead to negative results, which are then reinforced and produce more negative actions and results. For example, suppose that you make a hasty decision and lose money. Now the value of your account is a little lower and you are questioning your abilities. In an attempt to make the money back, you make another risky decision with poor results. The negative loop has started. (Looking to become a more disciplined, smarter and wealthier trader? Read 9 Tricks Of The Successful Trader.)
When an action is repeated enough times with similar results, the process becomes ingrained and establishes itself as a habit. The process of creating a habit is called a "conditioned response."
Why Is a Feedback Loop Important?
When it comes to trading, many traders know what they are supposed to do on a rational level. That said, they will still do something impulsive when certain pressures are applied. In other words, the trader will take an action that is based on a conditioned response or ingrained habit pattern instead of adhering to a rational thought process. (For more, read Master Your Trading Mindtraps.)
A typical example of a rational approach being in conflict with a subconscious pattern occurs when a trader prepares stop loss levels in the event that the market should go against his trade. But when the market actually trades down to the stop loss levels, he impulsively moves the stops out of the way in the hope that the market will turn around again. In short, the trader changes his plan rather than accepting a loss - even though his plan provided for it.
The Importance of Confidence
Confidence is the ability to create a trading plan and then execute according to that plan. In order to do this a trader must learn to stand outside of himself and become emotionally detached from the trade. When a trader creates a plan and executes, either making a profit or taking a small acceptable loss as allowed for in the plan, this creates a positive feedback loop. If trading is executed in this way and is repeated over and over again, then confidence is developed. (Discover what on-balance volume, accumulation/distribution and open interest can tell you about the market, see Gauging The Market's Psychological State.)
A trader must accept that even if he or she has a strong trading strategy, say one that can produce profitable trades 70% of the time, it still will have 30% losing trades. Haphazard trading and constant switching between different methodologies in the search for a non-existent "Holy Grail" will only harm confidence. A trader needs to strive to execute a trade in accordance with his or her trading plan and build a reservoir of positive experiences, even if a trade makes a loss. As long as taking a loss is part of the trading plan, your confidence won't be shattered.
How to Build a Feedback Loop
The best way to start building positive feed back loops is to start with a specific trading methodology and measure the expectancy of the methodology before actually using it to trade real money.
A methodology can be any one of a number of ways to take a trade, such as buying at a support level and selling at a resistance level, or buying or selling a breakout. These actions can be triggered by watching price and volume levels, or even by responding to the signals generated by mathematical indicators. What matters is the consistency of the method. (Dig a bit deeper with Gauging Support And Resistance With Price By Volume.)
Expectancy is the formula you use to determine how reliable your system is. You should go back in time and measure all your trades that were winners versus all your trades that were losers. Then determine how profitable your winning trades were versus how much your losing trades lost, assuming you have used a single specific methodology. You cannot measure expectancy if you are changing the rules of engagement for each trade.
Take a look at your last 10 trades. If you haven't made actual trades yet, go back on your chart to where your system would have indicated that you should enter and exit a trade. Determine if you would have made a profit or a loss had you followed the system and write these results down. Total all your winning trades and divide the answer by the number of winning trades you made. Here is the formula:
| E= [1+ (W/L)] x P – 1
W = Avg Winning Trade
L = Avg Losing Trade
P = Percentage Win Ratio
If you made 10 trades and six of them were winning trades and four were losing trades, your percentage win ratio would be 6/10, or 60%. If your six trades made $2,400 total profit, then your average win would be $2,400/6 = $400. If your losses were $1,200, then your average loss would be $1,200/4 = $300. Apply these results to the formula and you get: E= [1+ (400/300)] x 0.6 - 1 = 0.40 or 40%. A positive 40% expectancy means that your system will return 40 cents per dollar over the long term. (For more see Using Logic To Examine Risk.)
The Bottom Line
If you have a system with a positive expectancy it can be very helpful in building confidence since, more often than not, your system will produce a profitable trade. Every positive trade is recorded in your subconscious as positive feedback, which leads to the confidence to trade more using your tested methodology.
Trading in any market requires that you have sufficient knowledge of your market, adequate funding and a tested methodology with a proper set of risk management rules. Keep practicing by using simulated accounts until you achieve a level of confidence backed up by positive experiences. Then take the next step and use real money. You will become a much more accomplished trader by doing it this way.
For a free practice account, try our Stock Simulator.