Have you ever been in a losing trade as it approaches your stop and thought… “Let me just see if price bounces at the next level”? If so, you aren’t alone. This a common phenomenon that all traders experience during their early development stages. So, what is it exactly?
Post-purchase rationalization refers to the psychological phenomenon where individuals, after making a decision or purchase, tend to justify or rationalize their choice, especially if it was a difficult or costly decision. This cognitive bias is a form of self-deception, as individuals try to convince themselves that their decision was the right one, even if evidence suggests otherwise. People engage in post-purchase rationalization to reduce cognitive dissonance, which is the discomfort that arises from holding conflicting beliefs or attitudes.
In the context of trading, post-purchase rationalization can be closely related to the reluctance of traders to sell losing trades. This reluctance is often driven by the desire to avoid admitting that the initial decision to buy or take a particular entry was a mistake. In my experience in coaching and mentoring traders, those that struggle with admitting they are wrong (which is usually related to ego or misplaced confidence) will have the most trouble selling a losing a trade at their stop loss. Traders may engage in various cognitive biases and behaviors to rationalize holding onto losing positions, even when it goes against their best financial interests.
Why Traders hold losing positions too long
Loss Aversion: Traders may be more sensitive to losses than gains, a phenomenon known as loss aversion. The pain of realizing a loss may be psychologically more significant than the pleasure derived from avoiding the loss. Loss aversion is one of the main hurdles that holds traders back from consistent profitability.
Sunk Cost Fallacy: Traders might fall victim to the sunk cost fallacy, where they consider the money already invested in a losing trade as a "sunk cost" that should influence future decisions. They may be reluctant to sell at a loss because they don't want to accept that the initial capital is gone. This is especially prevalent with options - When the contracts are down 50-60%, most traders are going to be more likely to “hold and hope” rather than accept the loss.
Overconfidence Bias: Some traders may overestimate their ability to “predict” the market or believe that the market will eventually move in their favor. This overconfidence bias can lead them to hold onto losing positions, thinking that the market will eventually turn around. As traders, remember that we are not in the prediction business. We react to what price action and market structure provide us with.
Regret Aversion: Traders may fear the regret associated with selling a losing position just before it rebounds. This fear of regret can lead to inaction and a refusal to acknowledge the need to cut losses. When traders cut trades only to see them move in their favor shortly after, it reinforces the idea that they should just hold. You can always re-enter a trade idea - But you can’t always recoup that lost capital on the initial trade!
Commitment Bias: Once a decision to enter a trade in a particular asset is made, individuals may develop a commitment bias, feeling a sense of loyalty to their choice. This commitment can make it challenging to admit that the decision was wrong and take corrective action.
How to Sell That Losing Trade
Secure a Better Entry: One strategy to mitigate the impact of losing trades is to focus on getting a better entry. This involves improving the timing of entering a trade by utilizing technical analysis and leaning on higher timeframe market structure. You can wait for opportune moments, like pullbacks or trend reversals, to enter positions. By refining entry points, you can reduce the potential for immediate losses, improve your hit rate, and usually improve the overall risk-to-reward ratio of your trades.
Accept Your Maximum Loss Before Entering (Planning Your Trade): Every consistently profitable trader fully plans their trades in advance of their entry. This includes determining the maximum acceptable loss before entering a trade. Establishing a clear risk management strategy helps traders avoid emotional decision-making during adverse market conditions. By setting predefined stop-loss levels based on technical analysis or other risk parameters, you can ensure that losses are contained within acceptable limits, preventing larger and potentially more damaging drawdowns. Most developing traders are creating their trade plan after the entry is taken - With this approach, you fail to fully consider (and accept) the risk of trade prior to putting on any risk. This is problematic because the moment you take an entry and have risk on, is the moment your objectivity is gone.
Enter Close to Where You Know You'll Be Wrong: To improve the likelihood of minimizing losses, you can enter positions close to the levels where they acknowledge being wrong about the trade. This involves identifying critical support or resistance zones, trend reversal points, or technical patterns that would invalidate the trade thesis. This is why having a strong understanding of market structure is a valuable skillset. By entering trades with a heightened awareness of where you know you’re wrong, you can make more informed decisions about when to cut losses and limit the impact of the market moving against you.
Overcoming post-purchase rationalization in trading requires a disciplined approach, realistic self-assessment, and adherence to a well-thought-out trading plan. It's important to regularly reassess your positions based on current market conditions and information, rather than clinging to past decisions out of emotional attachment or a desire to avoid admitting mistakes. Setting clear risk management rules and having a predefined exit strategy can help you overcome the psychological biases associated with post-purchase rationalization. If you find that you continue to struggle with selling losing trades, sign up for our 1-on-1 Mentorship Program.