Experienced traders, successful investors, and renowned analysts emphasize the importance of trading in the stock market based on clear rules. While novice traders attentively listen to their arguments and advice, they often forget or are unwilling to apply them in practice. Most beginners make trades based on their feelings or unsupported judgments, leading to impulsive trading.
From this article you will learn:
- Impulsive trading can offer high returns but carries substantial risks and the possibility of complete capital loss.
- The lack of market analysis and ignoring data make the results of impulsive trading unpredictable and often unprofitable.
- Logical trading, based on clear rules and risk management, provides more stable results and minimizes losses.
Impulsive Trading and the Impulsive Trader
Many newcomers to the market encounter the following situation:
- The trader is out of the market, waiting for a signal from their trading system for a favorable entry.
- They observe a sharp movement in the asset’s price (regardless of direction).
- They perceive it as the start of a strong trend and make a trade, ignoring the signals from their trading system.
- The price chart reverses and starts moving in the opposite direction, resulting in a losing position.
In most cases, this scenario ends in failure – the investor has to close the trade to avoid critical losses.
This described situation is a prime example of impulsive trading. Another typical scenario involves:
- A prolonged decline in stock prices.
- The trader, convinced that a reversal is imminent, buys the shares.
- Prices continue to fall, resulting in losses. However, the trader’s confidence remains unshaken, and they buy more, averaging down the entry price.
- The decline pauses, and prices move sideways. Sensing that the anticipated reversal is imminent, the trader buys more.
- After a brief consolidation (forming a flag pattern), prices drop sharply, significantly increasing the loss.
This sequence of events will likely also end badly – several positions against the trend will quickly escalate the loss to a maximum permissible level, forcing the trader to close the position.
Besides these two examples, many other trading mistakes stem from impulsive trading. All of them are the result of impulsive trading.
The term “impulsive trading” refers to situations where a trader makes decisions not based on market analysis or trading system signals but rather on internal impulses. Its main driving force is the fear of missing out on an opportunity. It involves the fear of missing the right moment to enter or exit the market prematurely. The primary fear is not that the asset will move without them but that they will miss out on earning the expected (or maximum) amount!
As a result, every price movement generates an internal impulse, prompting the trader to open a position. At the same time, signals to close the position are ignored due to the desire to maximize the movement. Adherents of this trading style are called impulsive traders. Another term for them is intuitive traders, meaning market participants who make decisions without using fundamental and/or technical analysis tools, relying solely on their intuition.
Impulsive trading is contrasted with so-called “logical” trading, where trading decisions are entirely determined by the rules of a trading system. In logical trading, market entry and exit are performed by the trader strictly according to these rules.
The Advantages and Dangers of Impulsive Trading
The fact that impulsive trading is often illustrated by traders’ mistakes does not mean it has no right to exist. Moreover, the vast majority of even “logical” traders manually make trades that can be called impulsive. The issue is that any methods used for market analysis are difficult to call precise.
Decisions to buy stocks are often based on calculating multipliers. Yes, the results yield exact values, but the trader still chooses specific securities from dozens of similar options almost intuitively. When it comes to fundamental analysis, specifically comparing published macroeconomic indicators with previous or forecast values, the difference is easy to calculate accurately. However, its impact on the market and the assessment of possible price dynamics remain in the realm of intuition.
Even in technical analysis, where indicators are the result of mathematical processing of price charts, intuition still plays a decisive role. This primarily concerns input parameters, such as averaging periods. The trader has to select these to implement an optimal trading system. Even the most modern strategy testers offer little help here, as the trader compares their results and chooses the best option based on their subjective opinion.
Impulsive trading can yield excellent results. Publications on investing often cite the results of some impulsive traders who make dozens of trades without losses and quickly increase their investment capital.
It should be noted that impulsive entry into the market to capture the beginning of a movement and an analogous exit at presumed peaks can provide significantly higher returns than signals from any systems that follow prices. This is the greatest advantage of intuitive trading.
However, in most cases, its significant drawbacks more than compensate for this advantage:
- The impulsive trader does not analyze the market at all or ignores analytical data. This means they do not exploit market inefficiencies, so the probability of achieving a positive result in each individual trade remains uncertain. In effect, this makes profit and loss equally likely.
- Impulsive trading does not provide a positive expected value (as derived from the previous point). Therefore, the trader cannot achieve the desired trading results (profit) over the long term. Moreover, due to exchange and broker commissions and instrument spreads, their trading becomes unequivocally loss-making.
This leads to a discouraging conclusion – even if an intuitive trader shows excellent results in a series of trades, they are always just one trade away from losing their entire capital. This type of trading is contraindicated for investment!
The main advantage of a logical trader over an impulsive one is not in more accurately determining the moment to enter and exit a trade, nor even in the positive expected value provided by the trading system. Logical trading always includes strict risk management and mechanisms to limit losses. These are initially absent in impulsive trading, making the loss of the entire capital an exceedingly likely result.