Trading 101: An Introduction to Trading Psychology
What is Trading Psychology?
There is a lot more to trading than analysis, trading strategies and risk management. Managing your emotions when trading often becomes even more of a challenge than other technical aspects when entering the financial markets. Find out more about trading psychology below.
Trading, an emotional rollercoaster?
Trading can take you on an emotional rollercoaster as you experience periods where everything seems to go right followed by periods where everything seems to go wrong. This can lead to feelings of euphoria, greed and fear, which in turn can cause many traders to abandon their trading plan. Traders often find themselves taking trades that make them feel better rather than taking trades for the right reasons.
Remain disciplined while trading
Learning to manage your emotions is crucial in order to remain disciplined, especially when things are not going your way. The following are some examples of the way in which emotions can get in the way of profitable trading.
Fear as a volatility driver
Fear is the emotion that drives most of the volatility we see in asset prices. Fear also impacts individual traders in two ways. Firstly, the ‘fear of missing out’, often causes traders to jump into a trade at the worst possible price when the market has already moved. Rather than trading because there’s a real opportunity, traders enter positions to overcome the feeling that they are missing out.
Fear also causes traders to abandon a strategy at exactly the wrong time. Profitable strategies often experience a series of losing trades followed by a series of winning trades. However, inexperienced traders will often stop trading after a losing streak for fear of losing more money. This very often happens just before the losing streak ends, meaning they miss out on a potential winning streak.
The pressure to make profits
The pressure to make profits causes a lot of traders to overtrade and take marginal trades, rather than being patient and waiting for the best setups. Traders perform best when they only act according to the opportunities the market provides, not their P&L or a need to generate income.
Greed is also affecting traders
Greed can affect traders in a number of ways. Some traders take profits to soon because they don’t want to lose them. Or, greed can cause traders to hold on to winning trades when they should exit them, it can also lead to trading positions that are too large for the relative account size.
Revenge trading is another common side effect of emotion. This happens when a trader loses money and then tries to make it back quickly by increasing their trade size and taking random trades. This tends to end very badly for the trader!
How to avoid emotional trading
Many of the problems listed above are a result of trading positions that are too big. By reducing risk to the point that losses do not have an emotional effect, decision making can be made based on what the market is doing and not due to emotionally-driven decisions.
Keeping a journal – an effective way to curb impulsive behaviour
Keeping a journal is another effective way to curb impulsive behaviour. If you force yourself to write down the reasons for each trade, it could help you spot the trades you are making for emotional reasons. In addition, if you make a note of your state of mind at the time of each trade, you will begin to see patterns in your behaviour and thinking. This will help you to be on guard when there’s a good chance you will make impulsive decisions.
Education and books – probably the best solution
Finally, there are lots of very good books on the subject of trading psychology. Trading in the Zone by Mark Douglas and The Daily Trading Coach by Brett Steenbarger is a good place to start. The more you read the more you will learn about the subject and the more you will be able to manage your weaknesses and exploit your strengths.