Procedural Errors, which are natural human tendencies made much worse by Aversive Conditioning and Random Rewards.
Random Rewards, Mind Traps and trading with Scared Money will undermine your ability to follow a trading plan, leading to additional Procedural Errors such as reactive trading and intuitive trading.
Ultimately, this results in excessive risk aversion and negative expectancy from emotional wounding.
Lack of a Trading Plan
An awareness of risk stimulates planning and rule-based behavior. You wouldn’t jump out of a plane without being sure of the exact procedure for opening your parachute and having practiced it on the ground.
If you assume trading is easy or that you already have the necessary skills to trade successfully, then you will fail to formulate an adequate trading plan and fail to develop the skills to execute it flawlessly.
You will be tempted to leave too much to discretion. In trading, discretion should be only relied upon by advanced traders. For most traders, discretionary trading exposes you to the risk of random reinforcement, which produces a chaotic and even addictive state of mind. Hello Las Vegas.
One key to managing risk is to take losses while they are still small. Aspiring traders often want to avoid all losses, which inevitably leads to postponing the one loss that eventually becomes a huge losses.
The ‘Oh my God’ loss. Additionally, aspiring traders often form definite opinions about where the market is headed and have difficulty changing those opinions at the appropriate time.
These two psychological factors: postponing losses and inflexibility, need to be eliminated because they interfere with proper risk management.
Rules give structure to an otherwise chaotic flow of information and enable traders to be proactive.
Traders without a clear set of rules will find themselves riding an emotional rollercoaster, at the mercy of his or her instinctive emotional reactions to market movement and to gains and losses. These reactions are rarely conducive to profits.
The market is setup to stimulate primitive emotional reactions from reactive traders and take full advantage of them, without mercy. No wonder Jim Cramer uses the cry of baby as a sound effect on his Mad Money Show.
To trade successfully, you need to reduce procedural errors to minimal levels. One way to evaluate whether you are prone to make procedural errors is to look how well you follow rules and how you handle losses. Working on these things can help you eliminate procedural errors.
Until next time,
Dr. Kenneth Reid holds a Ph.D. in Clinical Psychology. He is currently a trading coach and has published articles for Forbes, SmartMoney, and SFO Magazine. He has also appeared on CNBC and writes a column on The Trading Psychology for Trader Planet. Kenneth Specialized in trading stock and futures and is working on a futures trading book.