Trading Psychology for Prop ChallengesThe Psychology of Losses

Loss Aversion

Genetically, losing the same amount of money is perceived significantly more emotionally than earning it. Simply put, evolution taught humans that losing, for example, day’s supply of food would most likely result in death, however the ancient mechanism still works. When applied to trading, the actual loss happens once the losing position is closed.

That leads to problematic behavior resulting in various wrong approaches leading to mistakes. For example, instead of accepting the mistake and closing the position with adequately pre-calculated loss, the trader keeps holding the position hoping that the market will suddenly reverse, what costs him even more money. In worse case, such behavior can result in breaching the daily drawdown and losing the challenge.

The above-mentioned behavior can be demonstrated by simple calculation. In case of $50,000 account, with 3% maximum daily drawdown, with $1,500 being the cap. He decides to buy 500 shares at $40, setting the stop loss at $39, which, according to risk management, is perfectly fine, as he risks only 1% of his account. Gradually, the price is moving to $39, where he initially put his stop loss. Once the psychology of loss aversion kicks in, he starts moving the stop loss, initially to $38.50, as he’s still within the maximum daily drawdown, however his unrealized loss is already at 1.5%. From the perspective of risk management, he’s entering dangerous territory. Since he opened the position based on certain assumptions, which are no longer valid, his approach is more similar to gambling, than the actual trading. Reluctant to realize even bigger loss, he keeps waiting, price drops to $37, meaning he’s already at daily drawdown of 3% and the challenge is over.

On the other hand, extreme aversion to loss can lead to fear of opening positions with adequate risk to reward ratio and high probability of being profitable. Consequently, the trader misses high-quality set ups. Furthermore, decreased activity for prolonged period can result in opposite psychological reaction, manifesting as attempt to compensate for the missed trades. Given the psychological pressure, as the trader feels he must open at least some positions, usually causes even more mistakes. The typical case is going for low quality set ups, based on one indicator, emotions, or misinterpreted piece of news, resulting in losses.

Certainty Trap

Loss aversion explains why losses bring stronger emotional reaction than wins. Certainty trap explains what the brain does about it. When applied to more specific situation, brain interprets uncertainty as threat in situations, where you already have something and that could be taken away, meaning you want to escape the situation by securing what you have, specifically in trading – closing the winning position.

On the other hand, when you are losing, the element of uncertainty is interpreted as opportunity to reverse the situation. More specifically, if the person has the opportunity to take the guaranteed $500 or the choice to flip a coin with 50% probability of winning – either $1,000 or nothing, it‘s statistically proven that the person will take the first choice in vast majority of cases.

The above mentioned phenomenon can be explained on a specific example. The position of 500 shares per $40, with stop loss at $39, could place profit target at least at $42, therefore resulting in 1:2 R:R. The mistake the trader can make, would be taking the profit at, for example $40.60 – falling to the certainty trap of closing the position with “guaranteed” unrealized profit visible in the trading platform, with realized R:R of 1:0.6, considered as highly suboptimal from the perspective of standard risk management. In general it’s highly unrecommended to go below the R:R of 1:2. Although the locked in profit might initially seem fine, the fallacy of such approach quickly compounds.

Open Trade Risk

Before entry, you have the whole picture. You can see the higher timeframe, the level that invalidates the idea, the coming macro data releases, the setups tracked on other instruments. You are calm because nothing is at stake yet, and calm is a wide state — attention spreads out, context stays available, and you can count on several scenarios at once without effort.

Once the position is opened, body starts to react differently. Heart rate slightly rises, breathing shortens. Attention pulls in toward the price — the one number that is currently moving your money — and everything at the edges quietly drops out of view. Although the panic is not there, brain has less mental room than it did five minutes ago, and the narrowing is invisible from the inside, which is the part that matters.

This is the brain doing its job, which hasn’t originally been trained for trading. The stress response evolved for physical threat, where narrowing attention onto the source of danger and preparing for immediate action was exactly right. Markets present similar, if not the same signature — uncertainty, stakes, no control over the outcome — therefore the brain responds the same. But the ancient response optimized for speed and focus comes at the cost of the two things trading actually requires: peripheral awareness and the patience to do nothing.

Under load, the brain stops processing new information and starts looking for confirmation that you’re fine. Time distorts, so a normal retracement feels like it’s lasting far too long. The urge to act becomes physical, and acting — moving a stop, closing early, adding — feels like relief regardless of whether it’s correct. None of this presents itself as emotion. It presents itself as a reasonable-sounding thought, which is why traders defend these decisions afterwards, although an independent observer could clearly explain why they are wrong.