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Endowment Theory: What Forex Traders Should Know

   

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It is amazing how many people I speak to about trading and how often the conversation eventually makes its way to the topic of cutting losses and exiting trades.  It is almost as if people accept that most of your trading success boils down to this single clearly identifiable task.

Whilst trading routinely involves decision making, there are not too many more important decisions you have to make than when to exit trades.  It is one of those items that you probably wish you knew when you first started trading – as a beginner, it is incomprehensible that your trade exits are so important to making money. 

Many traders often overlook this part of trading or underestimate how important that it is.  It is exiting your trades that directly impacts on whether you make any money trading.  Entering trades is simply a means of putting yourself in a position to make money from trading.

Endowment Theory

There is an experiment which has been widely conducted in Economic and similar classes around the world, which relates well to selling stocks.  It involves dividing a room of people into two groups.   Everybody in the first group is handed an imaginary coffee mug.  People in the second group receive nothing.

Everyone receives a small piece of paper and everybody in the first group is asked to write down how much they would be prepared to sell their coffee mug for.    Everybody in the second group is asked to write down how much they would be prepared to buy the coffee mug for.

All papers are passed forward and the amounts from all people within each group are compiled and an average calculated for each group.  Generally speaking, the average amount from the owners of the coffee mugs will be roughly double that of the average amount from the potential buyers of the coffee mugs.  This observation supports the Endowment Theory.

The Endowment Theory suggests that people who own something place a greater value on it than those who do not have it.  If you think to yourself now, this may apply to several material items that you may own.  You know that no one will pay you an amount that reflects the value you place on it.  

Trading Application

This theory is very applicable to trading and sadly, it can directly affect your decision making when deciding to sell stock that you should be selling.  Often you will find yourself owning stock where you believe that they should be worth more than what the present price is.  The only unfortunate thing about that is the real price is what it is presently trading for on the stock market and not what you think they should be worth.

Its practical application to trading is as follows.  Let’s say that you have entered a trade and bought some stock at $4.00 – you have placed your initial stop loss at $3.50.  In the two weeks after you enter, the price drifts down slowly and eventually moves down to your initial stop loss level.  Guess what?  You have just received an undeniable clear signal to exit the trade – the price has traded down to your previously identified stop loss price.  

Here starts the self-doubt, negative talk and the emotions begin to flare – perhaps frustration, or annoyance.  Thoughts begin to enter you mind about how it was only a couple of weeks ago that you paid $4.00 for them and how you think they are still worth that.  Especially when you consider the report they released last week concerning future growth, for example.  

The Endowment Theory now subconsciously kicks in – because you own the stock (remember, you made the conscious choice to purchase them with your money under no coercion), you deep down think they are worth more than the $3.50 presently being offered for them.  Due to this, you decide to not sell because you do not agree with the present price.  

The bottom line is, however, no one cares what you think the price should be.  Nor does it matter what the price should be.  The indisputable facts are that you purchased stock at $4.00 and now they are trading at $3.50 – your initial stop loss level.  

Relevance to Foreign Exchange Trading

Obviously when trading foreign exchange (FX), we do not purchase stock or even currency for that matter.  If we trade one full lot of EURUSD, we do not visit the broker’s office the next day and walk away with 100000 euro dollars in a briefcase.  All we are doing is speculating on the value of the relationship between the euro dollar and the US dollar.  

We are however making a conscious decision to do this based on analysis we have conducted.  Herein lies the potential problem.  We can easily be emotionally attached to analysis that we conduct and when price doesn’t head in our anticipated direction, we can become stubborn, perhaps obstinate.  

We can easily dig our heels in and stand by our analysis convinced that the market is illogical and doesn’t know what it is doing.  In other words, we do place a certain value on a financial product because of the emotional attachment we now have to our decision to enter the trade.  

While price is determined by supply and demand, it is important that traders learn that there are many inputs into that supply and demand.  There is the opinion of all the other market participants that matter, based on a myriad of things.  You may perform the best analysis on a currency pair and spend considerable time doing so, however if no one else agrees with you, then it matters for nothing.  If the majority disagree with your analysis, price will move in the opposite direction.  

Likewise, you will see other prices move considerably and for almost no reason.  Whether you think it is nonsensical, illogical, right or wrong, or anything else, it doesn’t matter.  At the end of the day, your opinion matters for nothing in the market.  What we think about a currency is not important – it is what everyone else thinks, that is important.  

There is a well-known saying in trading which says, “trade what you see, not what you think”.  The chart will tell you everything you need to know, and unfortunately in this environment, what we think and believe counts for nothing.  No one else in the market cares what we think.  So, remain objective and let the chart tell you precisely what is happening.  

It is fair to say that our emotions also play a part in this thought process.  Any subconscious thoughts can paralyse you to take no action and not cut your losses and consequently have you breaking one of the most important time-tested rules you can follow.  Do not let this happen to you.

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The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

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