When it comes to trading, knowledge is of paramount importance. Whatever approach you choose to base your trading decisions on – be it fundamental, technical, quantitative, or a combination, you need to have a solid understanding of that approach. Besides knowledge, the other factor that is important is the trading experience you possess. That said, there is one factor that is usually ignored by traders and is not spoken of as widely as knowledge and experience are, yet it is as important as these are, if not more. That factor is psychology. We commonly refer to it as Trading Psychology.
In this module, we will discuss various aspects relating to trading psychology. We shall talk about the basics of trading psychology and why it is such a critical aspect of trading, some of the common emotions and biases that traders face, how to control these emotions and overcome these biases, how to gain control of your mind and body, and then conclude by talking about some guidelines and suggestions pertaining to psychology. Over the course of this module, we shall primarily speak from a trading perspective. However, keep in mind that the concepts spoken would apply to investing too and not just to trading.
In this chapter, our objective is to introduce you to the subject of trading psychology and talk about the various emotions that traders face when trading.
Mindset: A critical part of Trading
As we said earlier, domain knowledge and experience alone are not sufficient to achieve trading success. A third factor that is equally important and has a strong say on one’s trading success is psychology. Unfortunately, traders, especially those who are new to trading, do not focus much on or are unaware of the psychology aspect and instead emphasise primarily on knowledge and trading strategies. Keep in mind that to achieve trading success, it is pivotal to control your mind and ensure that the decisions you take are rational rather than irrational.
What exactly does one mean by trading psychology? Well, trading psychology is the human mindset that is in play before, during, and after a trade. It represents the human emotions that influence one’s trading decisions. If you have ever traded, you might have experienced various types of emotions not only when you are in a trade, but also before taking a trade and even after closing the trade. How well you manage these emotions can separate success from failure. You may wonder how trading psychology can be as important as having domain knowledge and experience? Well, let us understand this using a couple of examples.
Example 1:
Let us say an experienced trader spots a good buying opportunity in a stock. He determines his entry level for the trade, the stop loss, and the take profit level. However, worried about a potential loss, he decides not to pull the trigger at the last moment and instead lets the opportunity pass by. See that despite possessing the necessary skill set and a good trade setup, fear of a potential loss prevented him from executing the trade.
Example 2:
Continuing with the same example as above, let us instead assume that the trader initiated the position. Post initiation, the stock started moving in his favour. However, despite the trade structure still looking favourable, the trader got nervous, cut short his winning trade, and booked profits on the position well before the target price was achieved.
In the above two examples, notice how emotion got the better of the trader and prompted him to act in a certain way, which he ideally should not have acted in. Had the trader stayed disciplined and not allowed emotions to take over, he could have achieved greater success in the trade.
Emotions that we face when Trading:
Although the above examples are hypothetical, this is something that even experienced and knowledgeable traders face when trading. Below mentioned are some psychology-related examples that traders can face when trading:
- Not executing a well-identified trade setup because of fear that you may incur a loss of capital
- Exiting a profitable trade early due to anxiety that price may reverse course than continue towards the take profit level
- Holding on to your winning position for too long due to greed, despite your analysis suggesting it would be good time to book profits
- Holding on to a losing position on hope that price will eventually start moving in your favour
- Averaging your losing trades to avoid losses, despite your analysis suggesting otherwise
- After a string of winning trades, getting overconfident and taking much greater risk than is defined in your trading plan
- After a string of loss-making trades, taking additional risks to recoup your losses, or starting to question your knowledge and experience
- Ignoring the rules defined in your trading plan and getting carried away by the market flow
These are some of the most common psychological barriers that traders face. Even if the trade is backed by solid research and analysis, one could still be prone to psychological barriers and let decisions be driven by emotions. This in turn has a potential to impede your trading success. Hence, besides possessing knowledge and experience, it is equally important to gain control over your mind, so that your decisions are rational rather than emotional.
In the sections ahead, we will talk about the most common forms of emotions that traders are prone to experience during trading: fear, greed, hope, and regret.
Fear:
Fear is a strong form of emotion that affects virtually all traders. It is also one of the toughest forms of emotion to deal with when trading. Even though a trader might possess sound knowledge and have a good amount of trading experience, fear is something that can still impair his or her judgement and decision-making abilities, even during times when the trader has spotted a good trading opportunity. When fear takes over a trader’s mind, it could cause a trader to act in an irrational way and quickly succumb to stress, which in turn could hinder trading success. Fear could arise due to various reasons as mentioned below:
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Fear of loss: As there is a great deal of uncertainty at the time of entry, a fear of loss could arise before executing a trade. If you are fearful at the time of entering a position, the impact could be cascading once entered. A small price move against you can cause you to panic, which in turn could affect your judgement with regards to not only the current trade but also other trades that you may have open.
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Fear following a string of losses: Fear could also arise when taking a position following a string of losses. For instance, if 8 of your last 10 trades went wrong, then even if you spot a good trading opportunity, you may be hesitant when taking the next trade or may exit the trade quickly before one of stop loss or target price is hit.
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FOMO: Another form of fear that you may encounter when trading is the fear of missing out, aka FOMO. This is especially common during powerful bull/bear markets. For instance, if a particular stock has rallied strongly and everyone around you is buying that stock, you may pull the trigger and decide to buy the stock yourself, even if your analysis suggests that the stock is overvalued and is not worth entering at present. What you are doing here is buying the stock not based on your analysis, but because everybody else around you are buying it and you fear that you might be left out of the rally entirely.
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Other factors that could give rise to fear: Increasing your position size, small capital, and taking excess risks are other instances that could give rise to fear at the time of or after entering a trade.
So, what sort of impact could fear have on your trading decisions? Well, below mentioned are some of the ways in which fear could affect your trading decisions:
- Cut your winning trades way too early due to fear that price may soon reverse
- Enter a trade prematurely for fear of missing out a part of the price move
- Enter a trade too late because of fear that you could miss out on the move altogether
- Refrain from entering because of a fear of capital loss, even if the trade setup is sound
- Refrain from entering a good setup because last few of your trades turned sour
- Fearing a loss of capital, randomly placing stop losses too close from the entry
- Constantly looking at the price and starting to panic in case things do not work your way
Greed:
Greed is the opposite of fear. Greed is an emotion wherein a trader:
- Holds on to his or her winning position(s) for too long and aims to capture the entire move, despite his or her trading system suggesting it would be time to exit or trim the position
- Following a string of winning trades, gets overconfident and takes on additional risk without even assessing his or her risk and money management principles
For instance, let us consider a situation wherein a trader executed a buy order at 100 and placed a stop loss and target at 95 and 112, respectively. Let us assume that the trade panned out as expected and hit his target of 112. However, despite the target being achieved and his trading system suggesting that now is a good time to book profit, the trader got greedy for more profits and held on to his position. What we have here is greed rather than rational decision-making influencing the trader’s decision.
Unlike fear wherein a trader takes little to no risk, greed is a scenario wherein a trader takes excessive risk. It would not be wrong to be occasionally greedy but allowing greed to influence your decision despite contrary/warning signals generated by your trading system and not revising your stop losses can be a disaster in the making. Imagine in the above situation, after achieving the target of 112, price rose to 113 and then fell all the way back to 95, hitting the stop loss. What we have here is a nice profitable trade that turned into a nightmare! If not controlled well, greed could cut down on your profits, or worse yet, lead to losses.
Greed is also a common emotion that develops late in the bull market. As the price rally accelerates and becomes near vertical, more and more participants join in the rally, sensing the easy money that is being made. The collective greed of all the market participants eventually causes the market to top out and usher in the distribution phase.
Hope:
In our day to day lives, hope can be a fantastic emotion. For instance, you could hope to become rich one day, you could hope to become a successful trader one day, and so on. In trading however, hope might not really be the most ideal of emotions to succumb to. When you enter a trade, it must be based on sound trading setup and the decisions that you take must be rational, rather than one based on the hope that price would behave as you want it to.
The emotion of hope tends to prevail the most among traders when they are caught in a loss-making position or have been stopped out but are still holding on to that position on the basis of hope that the current price move will reverse and allow them to cut down on their existing losses or better yet, exit at a gain. Keep in mind that holding on to losing positions just on the basis of hope that things would eventually work out your way is one of the worst mistakes that a trader could commit when in a trade.
Regret:
Regret is an emotion that could arise for various reasons as mentioned below:
- Regretting after exiting from a profitable position as the price continued to rise (in case of a long position) or fall (in case of a short position) following the exit
- After existing a profitable position, regretting that you did not trade a much greater quantity
- After cutting your losses and then seeing price reverse, regretting why you cut your losses
- After getting stopped and then seeing price reverse, regretting why you exited at the stop loss
- You found a good trade set up, but due to some reasons you did not execute the trade. Later, the trade worked very well, only for you to then regret why you missed the trade
- Seeing a particular security rise sharply or fall sharply and regretting why you did not trade that security
Aforementioned are just some of the situations wherein a trader could sense the emotion of regret. Unfortunately, regret is something that traders do face every now and then. However, it is important to not let this emotion have a bearing on your future trades. A very bad mistake that a trader could make is to allow the emotion of regret to get the better of him. If this happens, it is more likely than not that your next trade will be based out of emotion rather than rational thinking and a sound trade setup, which in turn could adversely impact the success of the trade and affect the mental wellbeing of the trader even more.
For example, let us say that a trader found a good trade setup in a particular stock. However, because of a fear of loss, he decided at the last moment not to execute the trade. Unfortunately, the trade worked out very well and well exceeded the target price. Seeing this, the trader regretted why he missed the move. Now, being overwhelmed by the emotion of regret and wanting to earn profits that was missed previously, the next trade that the trader took was taken emotionally and based on a poor setup. Eventually, the trade did not work out as expected, in turn affecting the mental wellbeing of the trader even more. Notice here how the trader allowed the emotion of regret to influence his next trade and paid dearly for it. Hence, it is very important to ensure that every trading decision you take must be independent of the success or failure of the prior trade and be free of any emotion.
Other forms of emotions:
Apart from fear, greed, hope, and regret, there are various other forms of emotions too. Examples include:
- Ego
- Overconfidence
- Frustration
- Anger
And so on…
However, most of these tend to be somewhat similar to one of the four emotions that we already spoke about earlier in this chapter. Overconfidence is kind of similar to greed, while frustration and anger and sort of similar to regret. For instance, when you are in a winning position, all the targets have been achieved, your setup is suggesting you book profits, and yet you are holding on to your position in a bid to maximize the profit. Well, we already saw that this behaviour is because of greed taking over your mind. Similarly, overconfidence could be another reason why you are holding on to your position well beyond a reasonable time frame and well past a good reward-ratio ratio. As a trader, it is critical that you control and manage these emotions and not let them affect your decision making when trading.
Now that we know the various forms of emotions that affect traders, it is time to focus on how to manage and control these emotions, keep them at bay when trading, and ensure that they have minimal impact on your trading decisions. We shall do over the course of this module. In the next chapter, we will focus on some of the most common trading biases that traders are exposed to.
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