Glenn Stok writes about investment and risk-control strategies he perfected in 45 years trading stocks, options, and futures contracts.
I've been trading stocks and options for over 45 years and discovered that eliminating emotional trading is the trick to be successful.
I'll explain how emotions negatively affect trading decisions and how to improve your results by learning to use a well-defined plan.
How Emotions Affect Investment Decisions
When we trade on emotion, we tend to do the wrong thing for the wrong reason. For example:
- We buy a stock in hopes that it will go up. Then it goes down, and we hold on because it would hurt our ego if we had to admit we were wrong.
- We tend to buy too high at times because we see a stock going up, and we want to get in on the action. We end up buying at the highest price out of greed, and then the stock tumbles.
- We don’t want to admit we are wrong, so we ride a bad trade down, making it even worse.
- We do get out at some point, but not when we should. We get out when we reach our pain threshold.
As you can see, when trading stocks on emotion, we tend to do the wrong thing. Instead, we can improve results by entering and exiting every trade based on a specific, well-defined plan and sticking to it.
Self-discipline is essential for successful trading. So let's review all that in detail.
How to Take Emotions Out of Investing
The only way to control emotions with stock trading is to make investment decisions based on a well-defined plan. That is known as mechanical trading.
I’m not talking about using software or any process that runs automatically. I’m talking about making your actions follow a strict rule of implementation.
It’s a strategy where you don't need to think. Entering and exiting every trade is based on specific rules. So you do it mechanically, no matter what else may affect your decision.
You might still be emotional about price movements, but as long as you’re diligent about following a well-defined plan, no matter how you're feeling about it, you will be more in control of ultimate success.
When you have a pre-defined plan, and you follow it instead of letting your emotions get in the way, you can increase your chances of buying low and selling high. That's how to avoid selling low out of panic or buying high out of greed.
To explain that another way, you need to exercise a buy and sell protocol that does not involve any decision-making.
How to Implement a Mechanical Trading Plan
You can do this with any stock, but I'll use the S&P 500 (symbol SPY) in my examples. That's an Exchange-Traded Fund (EFT), an index of 500 stocks in the S&P that you can buy and sell just like a single stock.
Based on your level of risk and the amount you have available for trading, choose an amount you want to invest on an ongoing basis. For the sake of this example, let's say $200 per month.
Start by buying $200 of SPY on the first trading day of next month.
Then, on the first trading day of every month, do one of the following:
- Buy $200 worth of SPY if the SPY is lower than it was on the first trading day of the prior month.
- Sell $200 worth of SPY if the SPY is higher than it was on the first trading day of the previous month.
You might need to round up or down since SPY does not trade in fractional amounts. You may use a different quantity for each trade and use a different period other than monthly. Whatever you do, keep it consistent—that's being mechanical.
Some brokers will let you specify the dollar limit, and they will adjust the shares accordingly, as shown in the example below:
Trading at a Specific Time of Day Is Crucial Too
Always make the trade at roughly the same time of the day as well. Otherwise, you’ll let emotion play with your decision. You’ll find yourself deciding to wait an extra hour or two on a fast-moving day, thinking you’ll get a better price. That can help, but it can also go against you.
Remember, when you let your emotion guide you, anything can go wrong. Whenever you buy a stock or ETF, there is always a 50/50 chance of the price going up or down. So it makes no sense to wait for a better entry or exit point with odds as even as that.
Adjust for Commissions
Many online brokers no longer charge trading commissions on actively traded stocks. Check with your broker. They might also have lower fees for EFTs.
If you do pay a commission, placing larger trades will reduce the cost. Calculate that into the price when executing the plan to buy or sell a fixed amount each month.
Whatever amount you decide to use, keep each monthly trade the same. At least as close as you can when rounding to whole shares.
Don’t Overthink Anything
By being mechanical, you'll never manipulate things against the rules.
You already made your plan—stick to it. Don’t change the amount of investment. You can use any amount, but don’t increase it because you're becoming greedy, and don't lower it out of fear if the stock is dropping.
I'll explain why these emotional responses work against you.
One month SPY may be so far down that you want to double your next investment. But don’t do it. It may be lower the following month.
You already would be getting more shares because you're investing a fixed amount each time. Be happy with that. It's known as dollar-cost averaging.
What if the stock goes higher? At first, you're upset that you didn't put more into it. Right? Then you want to put more into it because you feel you want to catch up. That's greed!
A trick I use is to ask myself, "Am I doing this out of greed?" But when I stick to a plan, I don't even need to think about it.
The beauty of mechanical trading is that you don’t need to think. You don’t need to follow trends. Just carry out your trades according to the plan—mechanically!
What’s the Benefit?
If you follow the plan I explained earlier, you will always be buying low and selling high. Thus, you will continuously be taking some money off the table at a profit rather than holding too long until things turn against you.
You will also be dollar-cost averaging as you buy more shares at lower prices and take some money off the table at higher share prices. That also creates a routine of recycling your funds.
What Can Go Wrong?
Nothing is a sure thing. World events can negatively affect markets. If the stock or ETF keeps going lower and lower, you could find yourself investing $200 endlessly every month until you have nothing more to invest. And you'd never have the opportunity to take money out at a profit.
Of course, the theory is that the stock market won’t go to zero. But to be honest, one never knows. You may need to change your plans if a crisis develops, such as war. That's the only time you'd sway from the method of this mechanical plan.
Recap of What to Remember
Develop a specific pre-defined plan that you can follow without thinking. Then follow these rules:
- Trade on the same day each month.
- Trade at the same time of the day.
- Enter trades mechanically based on the plan, not on emotion.
Emotions always cause us to ignore a known strategy. You'll see better results when you trade consistently according to a specific plan.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2014 Glenn Stok