Making trading decisions involves a lot of emotions, meaning it’s important to ensure that any choices are made rationally and with a clear conscience in mind.
Case in point, because the markets are volatile and can fluctuate seemingly at the drop of a hat, this can understandably provoke emotions: fear if the markets dip, the fear of missing out if the markets rally and you’re on the sidelines, and greed, which is linked to wanting to get rich quickly.
With that in mind, it’s important to understand and manage emotions accordingly when trading options to achieve the most success with your portfolio.
Common psychological challenges
Fear and greed
As previously described, fear is a key emotional factor that can impact decision making while greed can also impact decision-making. Not only are fear and greed emotions on a personal level but they have been linked to behavioural finance decision making, which is the psychology of analyzing investors’ habits.
In line with this, CNN Business developed the Fear & Greed Index to specifically measure investor sentiment and track what emotions currently drive the markets. As of the time of this writing, for example, current investor sentiment is fear, while the previous week was neutral, and one month ago it was extreme fear.
When it comes to fear’s impact on decision-making, it typically boils down to the fear of losing money, whether to take trades or exit a trade too soon that could lead to potential gains.
That’s not all, of course: other factors can even include the fear of missing out which can lead to making impulse decisions by diving into a trade without much knowledge. Geopolitical issues can also cause the markets to be volatile, leading to investors selling their options instead of playing the long game.
Greed, on the other hand, is tied with wanting to make as much money as possible and hopping on trends that can generate cash fast. Greed in options trading can also lead to investors holding onto trades for longer periods in the hopes of maximizing profits no matter the cost, which can ultimately lead to the complete opposite.
Overconfidence and illusion
Overconfidence bias, as defined by Science Direct, is “the unfounded valuations of stocks and believing in those confidently.”
When it boils down to it, overconfidence bias can lead to investors taking bigger positions in a trade than they should, which can also lead to greater financial loss.
Investors who boast overconfidence might also believe they can accurately predict which way the market will go. This can lead to them not adequately diversifying their portfolios.
As such, it’s important to avoid impulse trading to prevent financial impact that could in the end be harmful.
Loss aversion and regret
Loss aversion is described as investors experiencing a loss more severely than financial gains, which can relate to the fear of either holding onto a position for too long or selling it too quickly.
Tied to loss aversion is understandably regret, which can lead to investors being unable to define a bad decision or a smart one.
For example, an investor might hold onto a stock for too long after it’s dipped in the hopes that it’ll go back up again even though all signs point to that not being the case.
To control loss aversion, several key factors must be kept in mind, including being realistic about financial losses and conducting ample research into an investment.
Practical tips
While it’s easy to let emotions get the best of you, when it comes to finances and particularly options trading, staying neutral is the best course of action.
Create a trading plan
It’s easier to stay rational and keep your emotions in check when you have pre-defined strategies laid out that will help you stick to those pre-defined strategies.
These can include:
- Defining investment goals in advance
- Outlining your motivation
- Understanding market knowledge
- Assessing risk tolerance
- Deciding how much time you can actually commit to trading
- Tracking your trades
Risk management
In addition to outlining a trading plan, establishing a risk management one is just as important.
Some risk management strategies include:
- Finding a broker that works for you
- Planning your trades ahead of time
- Thinking rationally instead of emotionally
- Setting stop-loss orders and position limits
- Diversifying your portfolio
Mindfulness and self-awareness
Being self-aware and mindful is a powerful tool when it comes to options trading. Understanding what sets off emotions is key to managing a successful portfolio so decisions aren’t made in the spur of the moment.
Although it can be easier said than done, some ways to become more mindful and aware include recognizing what your emotional patterns are – for better or for worse. Track them if possible. Doing so will help you take control of your investments and regulate emotions during the highs and lows of the stock market.
Other factors include:
- Identifying strengths and weaknesses
- Staying disciplined and consistent
- Coping with stress and burnout
- Setting boundaries
Take breaks
Coping with stress and burnout effectively leads to taking breaks when needed to avoid burnout.
When trading becomes all-consuming it can be hard to see the forest for the trees, so taking a step back for even just a few days can provide much-needed clarity.
Taking a break can help reshift your mindset and perhaps even crack old, unhealthy trading habits.
One thing to remember is that trading is a marathon not a race, so taking a break might help you come back in a better mental and emotional state.
In conclusion
Like almost anything, developing emotional discipline is crucial for long-term investment success. Find ways that work for you that will keep your emotions in check to prevent losses.
And if something doesn’t work for you, you can always reset and try again: continuous self-reflection and learning are essential personally and, of course, financially, to see the results you want.
BMO InvestorLine Self-Directed can help you trade options with confidence with our resources and tools.
Get started with BMO InvestorLine Self-Directed today.
This article is prepared as a general source of information and is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this article does not constitute and shall not be deemed to constitute advice, an offer to sell/ purchase or as an invitation or solicitation to do so for any entity. The content of this article is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and makes no representation as to the accuracy, completeness or reliability of the content and hereby disclaims any liability with regards to the same. Any strategies discussed, including examples using actual securities, quotes and price data, are strictly for illustrative and educational purposes only and are subject to change without notice. BMO InvestorLine Inc. is not responsible for the information provided and disclaims all liability with regards to the same.
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