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The Disposition Effect

03/30/16 11:27:59 AM
by Stella Osoba, CMT

The psychology behind our tendency to sell winners and keep losers.

Security:   AMZN
Position:   N/A

Pay attention to your mental processes over decisions around selling out of your winning or losing positions. Often when a position is working you can become hyper vigilant. You watch every move that the stock price makes. Your anxiety increases on bear days and your spirits lift on bull days. As you watch your gains increase it is with increased apprehension that you study down days. This is risk aversion. Studies have shown that we are risk adverse when confronted with gains, but risk seeking when confronted with losses. So it comes as no surprise that traders are more likely to sell trades that are winning than trades that are showing losses. This is a psychological bias that comes from narrow framing. If you frame the decision to sell the winning trade as a way to prove to yourself that you are a successful trader, then you are likely to sell out of your positions too early. Often, in seeking to avoid the pain of a gain turning into a loss, you bail out of the position too soon, then watch from the side lines as the stock climbs to stratospheric heights. On the other hand, this sort of narrow framing will also cause you to be risk seeking in avoiding losses. You refuse to sell a stock that has performed poorly, telling yourself that you will sell when you get back what you paid for it so as not to have to take a loss. This risk seeking tendency in holding on to losses comes from the unwillingness to cause yourself the pain of having to deal with the blow to your ego of admitting you were wrong. This is a psychological bias known as the disposition effect.

For example, if you had decided to trade Amazon (AMZN) (Figure 1) the following scenario could have played out. On September 29, 2015, AMZN formed a higher low at $490.50. You waited for follow through and entered a long position at (1) on October 1, 2015 for $520. You held the position through the next two trading sessions and became increasingly pleased as your trade worked. But then on October 6, 2015, you watched with concern as the stock formed a bearish outside day. It was also a two bar reversal. Should you bail, you wondered? The next day closed slightly higher, but the doji that formed at (2) was hardly reassuring. So you decide on October 8, 2015, at (3) after watching the stock make an even lower close, to get out. You sell at $530 and congratulate yourself on a successful trade.

Figure 1. AMZN Daily. Example of disposition effect; enter at 1 but close too early for small profit at 3.
Graphic provided by:
But why did you close the trade when you did? What signals were confirming that the trade was no longer viable? It was likely the disposition effect at work. You had anchored onto the price you got into the trade. You then let that price dictate whether the trade was working or not. To have correctly traded this position, it would have been better had you ignored your entry price and once in the position, focused only on the charts. In any uptrend, reactions are normal. This reaction at 50% or less of the previous uptrend was not unhealthy. It did not spell any imminent danger for the uptrend.

So now you are kicking yourself for exiting your position too early. As shown in Figure 2, you watch the price gap up and so you go back in at (4), determined not to let yourself get shaken out this time. Shares top and trade sideways for weeks, but you hold on. You fail to notice the clear evidence of topping behavior at (5); no advance in price but higher volume on down days. Maybe you also fail to notice the three bar bearish reversal at (6) or the negative divergence formed by both RSI and MACD. Price gaps down, but you have told yourself you will not get shaken out of this trade. You therefore fail to get out when the chart tells you to. At (6) you still have a chance to get out for a small loss. But you hold on, trying to get back to even until at (7), when you can no longer stand the pain, you close out the trade.

Figure 2. AMZN Daily. Example of disposition effect; enter at 4, then ignore warning signs hoping for a profitable trade.
Graphic provided by:

Stella Osoba, CMT

Stella Osoba is a trader and financial writer. She is a frequent contributor to "Technical Analysis of Stocks and Commodities" magazine and " Advantage" as well as other financial publications.

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