In our Workshops we attempt to deliver students 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 centralex 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 investing 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?”
All of these terms can be summed up in one form – the impulse trade.
Impulse trades are bad because they are executed without proper analysis or method. Successful investors 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 this occurs all the time – even though these transactions 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 investing 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 transactions. However, in smart trading, a structure is in place prior to a transaction 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 decision.
Risk and Fear
The psychology behind taking an impulse trade is simple: the investor takes a risk because they are driven by fear. There is always fear of losing money when one plays the market. The difference between a good 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 investor 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 transaction – 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.