It is relatively easy to determine when to buy an asset. It is not so easy to determine when to sell. However, humans have a strong compulsion to hold onto assets, even in the face of obvious loss. Humans also have a strong compulsion to join in on buying a rising asset, even if it is priced too high. The result of these two ingrained behaviors is often buying high and selling low, the exact opposite of the desired outcome.
The reason for this behavior is emotion. Humans are emotional creatures. Emotion is the enemy of successful asset trading. Humans are also rational creatures. It is rational to devise a strategy, a trading plan that eliminates emotion, and stick to it.
When a proven plan is put into place that eliminates the emotion of trading, then the trader can rest assured declining asset prices don’t have to end up as a catastrophic event.
CryptoStops risk management tool uses trailing stops. A trailing stop is a price set at a defined threshold below the current price of the asset. As the market price of the asset rises, the trailing stop price also rises. If the market price falls, the trailing stop price does not change. By using a trailing stop an asset will not be sold too early or, in the case of falling price, held for too long. Research shows that traders who use trailing stops in a disciplined way average higher returns than those who don’t.
Trailing Stop Example – 25% Decrease
Time Point 1: Asset purchase price = $10. Trailing Stop percentage = 25%, therefore = $7.50
Time Point 2: Asset price decreases from $10 to $8. Trailing Stop not met, therefore notification = No
Time Point 3: Asset price increases to $20. Trailing Stop price now $15 (still 25%). Notification = No
Time Point 4: Asset price decreases to $16. Trailing Stop still = $15 (as price decreases Trailing Stop price remains constant as measured against the highest price attained). Notification = No
Time Point 5: Asset price increases back up to $20. Trailing Stop price still = $15. Notification = No
Time Point 6: Asset price decreases to $14.90. This is less than $15 and greater than 25% decrease from highest price attained. Notification = Yes
Time Point 7: Asset price continues to decrease, but was sold at 14.90.
The choices we make as human beings often don’t line up with the choices you would think a rational person would make. Daniel Kahneman and Amos Tversky theorized that traders are risk-seeking when it comes to losses, but are risk-averse when it comes to gains (Prospect Theory: An Analysis of Decision under Risk, 1979).
According to Kahneman and Tversky, when traders have losses they are willing to take bigger risks to try to avoid those losses. They feel like they need to recover, to get back to a break-even point. When traders have sizable gains they tend to want to sell to “lock-in” those gains.
Kahneman and Tversky, March 1979, Blackwell Publishing Ltd. Permission courtesy of John Wiley & Sons, Inc.
This behavior is represented by this figure. The left side of the figure shows losses and the right side shows gains. As losses increase, shown by the line moving from left to right, the emotional effect of those losses increases. However, as gains increase the positive emotional effect levels off. This shows that losses have more impact emotionally than gains. This is what causes us to sell assets that show positive gains and hold onto assets that show loses.
So, in summary, putting a trading plan in place that includes using trailing stops will help to remove the emotion from your decisions and allow two things to happen more often than not: you will accept small losses rather than taking big losses, and you’ll let your winning assets run as opposed to selling them too early.