Thoughts, Trading

The Psychology of Countertrend Trades

This post examines the psychology of impulsively taking countertrend trades in violation of one’s trading plan, as opposed to the psychology of adhering to a logical trading plan to take countertrend trades.

Types of Countertrend Trades

During my trading journey, there are two types of countertrend trades that I find myself taking that I logically know I should not be doing:

  1. When I missed the boat of a good trend, and “felt” that the price has gone too far in one direction
  2. When I exit my profitable trades earlier than what my trading plan dictates

So what was I thinking (and feeling) when I took those impulsive trades? Why did I feel or think that way?

Our Psychological Immune System

To examine that, first take a quick detour to a very interesting TED talk by Dan Gilbert, titled The Surprising Science of Happiness (watch the video here). I have written a quick summary of the points in this article

Inside the Mind

When I impulsively take the first type of countertrend trades (i.e. missed a good trend), here’s what is going through my mind:

  1. Woah, the move has already gone quite a distance.
  2. Sigh, I should’ve taken that entry earlier. I shouldn’t have followed my trading plan so strictly.
  3. Should I get in now? No, I cannot get in any more, I cannot chase the market, it’s too risky, I have no logical stop nearby, you don’t know when it might reverse down quickly.
  4. I have already missed the move. I need to wait to enter in the opposite direction when the trend ends.
  5. The trend has gone too far, it must turn soon
  6. Look! There’s a bit of resistance, the trend is about to turn, go short! (for an uptrend)

And the countertrend trade is made! Below are what I think are the psychological process at work:

  1. Observation
  2. Regret
    • Trading is always full of regrets. You always think you can do better.
  3. Indecision, uncertainty, anxiety
    • Fear of losing out starts to take hold.
    • When you don’t have a well-defined trading plan that caters for all scenarios, or if you don’t believe in your trading plan, you will face indecision and anxiety.
  4. Resignation
    • I  accepting that I can no longer enter in the direction of the trend.
  5. Synthesized happiness (sour grapes)
    • By cutting off that possibility (or imposing a self-restriction on my flexibility), my psychological immune system gets triggered to synthesize happiness.
    • My non-conscious processes immediately ‘downgraded’ the idea of trend continuation (if I can’t get on, the trend must be bad), and boosted the idea that the trend will end.
  6. “Makes sense” stopping rule, rose-tinted glasses (read this for more details)
    • My logical mind starts to look for evidence to support my subconscious mind’s assessment.
    • Once the logical mind sees any supporting evidence, e.g. momentum waning, some resistance, it will stop thinking and conclude that my subconscious mind’s assessment is right. Hence a countertrend trade is taken.

Changing the Path

OK. Now that we have mapped out what exactly happened, how can we change the path to lead to the different conclusion the next time? Well, I think there are two ways:

  1. Have a method in your trading plan that allows you to get onboard a runaway trend.
    • E.g. a breakout, or even a punt.
    • When you have a method defined in your trading plan that allows you to get on, the indecision in Step 3 above will be replaced with anticipation and waiting for that trigger to hop on to join the trend. In that way, Steps 4, 5, 6 are cut off, the resignation step doesn’t occur, sour grapes thinking doesn’t happen, and our logical mind doesn’t look for faulty evidence.
  2. Accept that you cannot get onboard a runaway trend, and apply the usual tools (logical reasoning, visualization training of the subconscious mind, etc.) to effect that behavior.

Psychology of Exiting a Trade Early

Lastly, the psychology of taking a countertrend trade to exit an existing position has some similarities with what we discussed above. When you have an existing winning position, you fear losing what you have. When you don’t have a position, you fear missing out on the gains (which is also a form of loss). However, the psychological processes involved are probably simpler. Here it is probably just anxiety, leading to rose-colored glasses, leading to an impulse action (read this post for more details).



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