Note: The present article is an excerpt from: Effects of a five-week e-learning intervention on emotional competence, Hövelborn, 2018
Background & Theory
Unlike investing, which speculates on an increase in the underlying asset (e.g. a stock, commodity, or metal), trading can also profit from falling prices. This is possible through so-called short sales, which create a simple differential transaction between traders and brokers, the interface between the trader and the stock exchange.
This also allows traders to hedge future stock market transactions and to compensate for losses in the event of a stock market crash or to benefit from them. For several decades, the explanation of financial decisions was based on the efficient market theory (Fama, 1970; Samuelson, 1965). This states that the prices of assets are determined by all publicly available information, creating an unpredictable market and all traders acting rationally. This theory is supported by further works that have shown an important connection between rational decision-making processes and emotions in the economic context (Damasio, 2006; Elster, 1998; Grossberg & Gutowski, 1987; Lo, 1999; Loewenstein, 2000; Peters & Slovic, 2000).
Criticism of this model is supported by research findings that show an influence of irrational behavior and action.
These include exaggerated confidence (Barber & Odean, 2001; Gervais & Odean, 2001), overreaction (Bondt & Thaler, 1985), loss aversion (Kahneman & Tversky, 1979; Odean, 1998; Shefrin & Statman, 1985), herding behavior (Huberman & Regev, 2001; Wray & Bishop, 2016), misjudgment of probabilities (Lichtenstein, Fischoff & Phillips, 1982), and regret (Bell, 1983; Clarke, Krase, & Statman, 1994).
For these reasons and the clear deviation from the efficient market theory, the field of behavioral finance (Shefrin, 2001) emerged. This area of research came into focus, not least, during the financial crisis. For example, Akerlof and the later Nobel laureate Shiller of Yale University (2009) attributed the financial crisis and the stock market crash, at least in part, to an exaggerated confidence of large market participants, which resulted in too high investments in too dangerous ventures.
And this, contrary to the efficient market theory, happened despite clear and unambiguous information.
It is therefore becoming clear that decision-making in the financial context can be both rational and irrational in nature.
Trading Objectives
Before delving into emotions in trading, it is important to understand the objective of successful trading. At the end of the day, as with any other business, it is about generating positive numbers. Without going into tax and other aspects, the profitability of a mathematical nature depends on exactly two variables.
Thus, the probability of a system and the average risk-return ratio, known as the profit factor (PF), result in profitability. This is also known in economics as the return on investment (ROI). It indicates how much is earned on average per invested, more precisely, risked capital. If the PF is 1, it is a business in which money is simply exchanged. If the factor is less than 1, money is lost.
The opposite applies to a PF which exceeds 1. A successful trader always manages to classify his trades in a niche where he enters into an expected PF of at least greater than 1. Whether this is mathematically due to the high probability of success or an excellent risk-return ratio is initially irrelevant. An example of this is:
Trader (a)'s statistics show 40 winners, 60 losers, an average profit of €337, and an average loss of €100 after 100 trades.
The formula for the profit factor:
(Number of winners / Number of losers)
x (Average height of profits / Average height of losers)
= profit factor of 2.25This means that Trader (a) gets back an average of 2.25 times his risked and, in this case, invested euro per trade. Trader (b) had a significantly better hit rate. He won 60 trades out of a total of 100, thus losing 40 at an average profit of €150 and an average loss of thus €100. The PF is the same for Trader (a) as it is for Trader (b) according to the formula. It is assumed that the perceived emotions looked significantly different for the two traders.
Conclusion
In summary, the first prerequisite for successful trading is a mathematically understandable niche that must be entered into and maintained in every transaction. This rational basis is opposed by a plethora of irrational behaviors that are capable of having a negative impact on the rational niche. A more profound understanding of emotions and their effects on the simple objective will be examined more closely in the following article.