The disposition effect: why you cut winners and keep losers

The disposition effect is the tendency to sell winning trades too early and hold losing trades too long. In 10,000 brokerage accounts, investors sold winners about 1.5 times as readily as losers, and the winners they sold went on to beat the losers they kept (Odean, 1998).

Hersh Shefrin and Meir Statman gave it its name in 1985 (The Journal of Finance). It is one of the most consistent findings in behavioural finance, and day traders are not exempt. The same pull that keeps a stock investor in a losing share for months keeps you in a losing EURUSD trade for another twenty minutes.

What did the research find?

Terrance Odean studied the trading records of 10,000 accounts at a US discount broker from 1987 to 1993. On days investors sold something, he compared how many of their winning and losing positions they chose to close.

The habit was not explained by rebalancing or trading costs, and it lowered returns. The only month the pattern reversed was December, when investors sold losers for tax reasons.

What does the disposition effect look like in day trading?

• Closing a winner at a third of your target because "it might come back", while the loser runs to the full stop and beyond.
• Moving your stop further away as price approaches it.
• Taking profit on the first small pullback, then watching the trade hit your original target without you.
• Refusing to close a losing trade before the session ends, so the day is not officially red.
• Adding to a loser to improve your average price, covered in the sunk cost fallacy in trading.

The maths is unforgiving. With a 60% win rate, an average win of 0.5R and an average loss of 1.5R, you lose 0.3R per trade on average: 0.6 x 0.5 minus 0.4 x 1.5. A good win rate cannot save a strategy whose winners are cut and whose losers are left to run. Therisk reward ratio you planned only counts if you hold it.

Why do traders sell winners and hold losers?

• Loss aversion. Closing a loser makes the loss real, and losses weigh roughly twice as much as equal gains (Kahneman and Tversky, 1979). Keeping the trade open keeps the hope alive. More in loss aversion in trading.
• The break-even pull. After a loss, any option that offers a way back to zero looks unusually attractive (Thaler and Johnson, 1990). Holding the loser is the cheapest way to keep that option open.
• Pride and regret. Closing a winner feels like being right. Closing a loser means admitting you were wrong, so you put it off.

How do you stop the disposition effect?

1. Set stop and target in the platform before you enter, not in your head.
2. Never widen a stop. Allow yourself to move it toward profit only.
3. Judge every exit with one question: would I open this exact trade now, at this size? If not, close it, whatever the P&L says.
4. Measure it weekly. Compare your average win and average loss in R. If your average loss is larger than your average win on a plan that targets 1 to 2, the disposition effect is running your exits.
5. Cap the day. The worst holds happen late in a red session, when the urge to finish flat is strongest. A daily trade limit or daily loss limit ends that session before it gets there. EmotionLock enforces both on MT5.

The disposition effect is one of several biases covered in our guide totrading psychology.

Sources

1. Odean, T. (1998). Are Investors Reluctant to Realize Their Losses? The Journal of Finance, 53(5).
2. Shefrin, H. and Statman, M. (1985). The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence. The Journal of Finance, 40(3).
3. Kahneman, D. and Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2).
4. Thaler, R. H. and Johnson, E. J. (1990). Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice. Management Science, 36(6).

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