Learn to Trade Stocks Mechanically to Avoid Emotional Investing
I’ve been trading stocks and options for over 40 years, and I’ve discovered that the trick to be successful is to eliminate emotional trading. It wasn’t easy. Greed would interfere with trading decisions.
How Can 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 our ego would be hurt if we admit we were wrong.
- We also tend to buy too high at times because we see a stock going up, and we want some too. 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 the pain is too much.
How to Take Emotions out of Investing?
The only way to control emotions with stock trading is to make investment decisions mechanical. 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. You do it mechanically, no matter what else may affect your decision.
That is easier said than done, but it’s doable as long as you’re diligent about it.
The idea is not to let your emotions get in the way. Therefore you can increase your chances of buying low and selling high instead of selling low out of panic or buying high out of greed.
You need to exercise a precise buy and sell protocol that does not involve any decision-making. That is how you avoid letting emotions get in the way.
How to Implement a Mechanical Trading Plan
It's better to trade an index of stocks, such as the S&P 500 (symbol SPY). That's an exchange-traded fund (EFT) that you can buy and sell just like a stock.
Based on your level of risk and the amount you have available for trading, choose an amount that you will invest in equal sums at a time. For the sake of this example, let's say $1,000.
Start by buying $1,000 of SPY on the first trading day of next month.
Then, on the first trading day of every month (on an ongoing basis), do one of the following:
- Buy $1000 worth of SPY if the SPY is lower than it was on the first trading day of the prior month.
- Sell $1000 worth of SPY if the SPY is higher than it was on the first trading day of the prior month.
You may need to round up or down since SPY does not trade in fractional amounts. You may use a different quantity for each trade, and you may 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:
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.
Whenever you buy a stock, there is always a 50/50 chance of the price going up or down. That is true for ETF’s also. With odds as even as that, it makes no sense to wait.
- Trade on the same day each month.
- Trade at the same time of the day.
- Enter trades based on a rule, not on emotion.
Adjust for Commissions
If you pay $10 per trade and you trade $1,000 monthly, you are paying 12% per year in commissions. It would be best if you considered commissions when deciding what your monthly trade amounts should be.
As of January 2020, many brokers no longer charge trading commissions on actively traded stocks. Check with your broker.
Your broker might also have lower fees for EFTs. Charles Schwab’s ETF OneSource™ account is commission-free to trade some specific ETFs online.
If you do pay a commission, larger trades will reduce the effect of the commission. 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.
Be Strict and Don’t Overthink
Being mechanical means that you should never manipulate things in any way by thinking about it. 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 just because you're becoming greedy, and don't lower it out of fear.
Just stick to the mechanical nature of carrying out the plan. Fear and greed are two emotions we want to avoid.
What can happen when you don't stick with the mechanical method of consistency? I'll give you an example.
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.
The chance of going in any direction is always 50/50, no matter how far it moved up or down. It took decades for me to learn that as a fact, even though I always knew it from a statistical viewpoint.
The beauty of mechanical trading is that you don’t need to think. You don’t need to follow trends—or the news—or individual stocks. Just carry out the trades according to the plan—mechanically!
What’s the Benefit?
If things go according to plan, you will enhance your ability to buy low and sell high. 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 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 money. It’s almost like creating an endless stream of funds in a sort of way.
What Can Go Wrong?
Of course, nothing is a sure thing. World events can negatively affect markets. You could find yourself putting $1,000 into your account endlessly every month because the ETF keeps going lower and lower until you have nothing more to invest.
The theory is that the stock market won’t go to zero, but 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 mechanical nature of this plan.
The End Result
Despite the negatives with a constant down-market, this plan forces you to invest with dollar-cost-averaging—buying more and more shares at lower and lower prices.
When the market turns upward again, you’ll have accumulated a lot more shares at better prices. And you’ll be selling shares at higher and higher prices with this plan—if you stick to it.
What do you struggle with the most?
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