In academic terms, the Disposition Effect is a psychological bias in traders and investors to take profits quickly and let losses run. This is something which has been talked about in the markets for many years. It comes from a combination of risk aversion effects and a bias toward certainty over uncertainty. In other words, we humans generally prefer a sure gain, even when there is the prospect for a bigger one, while at the same time we prefer having the prospect for a smaller (or no) loss, rather than a sure one.
It’s pretty easy to see how these biases can turn into being quick to book a gain, but giving the market a chance to turn around rather than taking a sure loss.
It is to avoid the potential negative outcomes from this bias – not making as much as we should on winning trades, and taking losses which are much bigger than they should be on the bad trades – that we introduce systems and processes in our trading. For some it goes as far as strictly mechanical trading. For others it includes rules about where to place stops and how to move them up with the market. They attempt to enforce a discipline on us to avoid allowing psychological biases like the Disposition Effect to negatively impact our performance.
Keep in mind, however, that this needs to apply to social trading as well.
In most cases, when using an auto-trading or mirror trading system like Trade Leaders you have the ability to make changes to trades that are done in your account. As a result, there may be the temptation to close out or cut-back a winning trade before it is done by the trader you are following. This is not something that is good idea.
Consider the math of trading performance. Expected returns follow this formula:
R = (win% x avg. winner) – (loss% x avg. loser)
If you close out winning trades early you are impacting the size of the avg. winner. That lowers R - the expected return. This could go so far as to produce a negative expectancy in the most sensitive systems.
In other words, as a social investor you need to ensure you abide by very similar discipline as you would if you are trading in your own right. Don’t let the Disposition Effect drag down your performance.
Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.