What is trading psychology and why is it important for traders?
Having the right strategy would mean little if a trader does not pair it with sound trading psychology. It is imperative to have control over one's own emotions and this is deemed to be one of the most important traits for a successful trader.
A trader will need to approach trading as a business, and becoming emotionally involved can be detrimental to the business’s success. This is why understanding and subsequently adopting the right trading psyche is crucial for any trader.
In this article, we will cover exactly what is trading psychology, how important it is to develop a strong trading psyche, and how to avoid the downfalls of emotional trading.
What is trading psychology?
Trading psychology describes how a trader handles generating gains and handling losses. It represents their ability to deal with risks and not deviate from their trading plan. The emotional aspects of investing will attempt to dictate your every transaction, and your ability to handle your emotions is part of your trading psychology.
It is impossible to eliminate emotions in trading, but this should not be the goal in the first place. Instead, traders should understand how certain biases or emotions can affect their trading and use this information to their advantage. Every trader is different, and there is no simple rulebook that everyone should follow.
The basics of trader psychology
Fear and greed are powerful emotions that can dominate the trader's thought process throughout their trading career. The goal is to learn how to harness these emotions and develop a winning mindset.
A trader can use several techniques to create a strong trading psychology and maintain discipline. Besides reading books by trading psychologists and expert investors, you can also create a trading plan. Developing a trading plan will help you stick to a solid routine and avoid concentration gaps and loss aversion.
When beginning to trade, emotions can definitely run amok. If an asset's price moves quickly, a trader might start to fear that they are missing out. This is especially so for beginner traders and is a constant emotion that will frequently appear. Other emotions to manage are greed, fear of losing money, and the mental fortitude to overcome mistakes that have been made. Last but not least, one of the more critical aspects of developing a trading psyche is learning how to manage risks.
Traders sometimes have to make snap decisions. Even if you follow your trading plan, there could be certain situations where you are forced to make a quick decision. However, having a proper trading strategy and plan in place will help you manage your emotions and make sure that you don´t end up making too many snap decisions driven by your emotions.
Greed is another major hurdle many traders need to overcome. The objective of trading is to generate profits - or in other words, to make money. However, you need to have the right mindset. Set a goal for yourself (for example, percentage return per month) and work towards it. Never let greed control your actions.
A good way to work on your trading psychology is to never stop researching. Markets evolve all the time, and you may need to adjust your strategy from time to time. You may also find that you personally have changed as a trader, which is why keeping a trading journal is invaluable.
The fear of missing out (a.k.a. FOMO) is the feeling of missing out on a big opportunity. If you hear from your fellow traders how much they have earned by going long on Bitcoin, you might be tempted to just blindly jump on the train because you don´t want to continue missing out. This is not the right approach.
There will always be opportunities in the market, and you should enter trades based on your trading plan, not simply because you are afraid of missing out on a potential profit.
The importance of developing a trading psychology
One of the biggest hurdles for every trader is the fear of loss and making mistakes. Unfortunately, when trading, it is inevitable for one to take risks that might result in losses. The emotion of fear of losing out is otherwise known as loss aversion. To overcome this, a trader needs to approach their trading activities similarly to how a business is run.
A good method is to focus on statistics and referencing data while preventing emotions from driving any trading decisions. Beginner traders should especially consider building this habit as part of their trading psyche before their first transactions.
Another method to develop a healthy trading mindset is through the creation of a routine. This routine can include a premeditated way of starting the day. For example, a trader might consider initially catching up on data that was released while asleep. This could be followed by checking your positions and reevaluating your risk management.
Improving trading performance is based more on how you learn rather than what you learn. Therefore, this reinforces the need for a routine as it is key to learning and understanding the proper way to trade.
Trading mistakes and how they may negatively impact a trader's psychology
One of the most common trading mistakes made by beginner traders is entering positions based on gut feel, or intuition, without having a specific strategy. This arises from a lack of proper information and data, which results in a fear of potentially missing out on a golden opportunity. This subsequently leads to the fear of losing money and holding positions, which allows losses to build up.
Thus, to avoid falling into this vicious cycle, besides having a trading plan, a trader must remain disciplined. Ensure that each trade undertaken adheres to the rules or goals that have been outlined. Trading based on gut feel without a sound risk trading plan is a mistake.
To avoid these mistakes, you want to develop a risk management system, which determines:
- Stop-loss level
- When to take profit
- Any potential trailing stop loss
- Indicators that help confirm stop loss levels and take profit levels
Getting into a successful trading mindset
Being able to adopt a successful trading mindset is not something that can be done from the get-go. To develop a robust trading mindset, it takes time and a certain level of patience to learn from successes and mistakes.
A good method to aid that is to practice trading with a demo trading account. It will help in honing a good trading psyche while allowing a trader to polish their trading skills and techniques. Most importantly, it comes with no risk!
By spending a certain amount of time trading on a demo account, will help a new trader gauge the ups and downs of price action, and the rollercoaster of emotions that entails when trading, which ultimately helps to build confidence.
As with most successful traders, do not let the fear of missing out be the force to distract you from a trading strategy. Staying disciplined is a critical psychological practice that will help traders gain success.
Can bias affect a trader's psychology?
Yes, it can. Below we will look at some of the most common biases that affect traders.
Gambler's fallacy
People can misunderstand the concept of randomness. A good example is roulette. The odds of the roulette ball falling on the colour black are not rising just because it dropped on the red colour several times before. The same principle applies in trading - just because you had five losing trades in a row doesn´t mean that you are more likely to hit a winning trade on the sixth attempt.
Anchoring bias
An example of anchoring bias is if a trader is entirely focused on the price of where they entered a trade. This price is completely irrelevant to the rest of the market, but it is not to the trader.
Let´s assume a trader buys EUR/USD at 1.1950. The currency pair drops shortly after that, and the trader keeps thinking "I just need the price to return to 1.1950 and I can exit at breakeven". While 1.1950 becomes an important price level for our trader and he bases everything around it, the market does its own thing.
Hindsight bias
If you look at a chart and try to visually identify good trade opportunities in the past, you will find plenty. The recent top in the EUR/USD was "so obvious" - or the USD/JPY bouncing back off a certain support level "could not have been any clearer". We pretend that things that already happened were easy to spot, but they were not at that time. Especially if you operate under pressure and actually need to click on that buy or sell button.
Confirmation bias
Traders need to stay objective. When you are facing a losing trade, you should face reality and not just seek proof that you are right and the market is moving in the wrong direction. This could end up being an expensive mistake.
Negativity bias
Traders affected by this tend to expect a negative outcome rather than a positive outcome. While it is not bad to remain cautious in trading, too much negativity can drain you and prevent you from pulling the trigger - even when there are great trading opportunities available.
How to avoid emotional trading
It is not about getting rid of your emotions, but rather about understanding and controlling them. To achieve this, a trader must:
1. Have a solid trading plan
You need to have a clearly defined plan - which system you will use (whether it is fundamental analysis, technical analysis, or a mix of both), its advantages and disadvantages, how you will identify trades, and how you will manage them.
This needs to be accompanied by a trading journal, where you can write down your observations, identify your weaknesses, and build on your strengths which can help you avoid common trading mistakes and become a profitable trader. Jumping from strategy to strategy will do no good and emotional trading will take over.
2. Understand their risk appetite
Some traders might be comfortable taking larger risks and manage to keep a cool head even if they are facing a not-so-small drawdown. However, if you are just starting or generally have a lower risk appetite, this is unlikely to end well. You first need to identify your own risk appetite and plan accordingly.
3. Know when to take a break
If you feel stressed and exhausted, you are more likely to make mistakes or engage in revenge trading. It could be a good idea to set a rule for yourself that will define after how many consecutive losing trades you will take a break and stop trading until you have reviewed what happened.
After all, it is not just trading that can cause stress and lead to a losing streak. There could be external factors that are having a negative impact on your mental state, and it is perhaps better to take a break from trading should you be facing such a situation.
How to improve your trading psychology
Being able to develop and hone one's trading psyche is closely aligned with success as it helps a trader to keep calm in hectic market environments. By obtaining a deeper understanding of the fallacies that might arise, sounder judgment will prevail.
However, to do so is not easy as traders can make inferences that are highly subjective. It is always more beneficial to look at data and utilise a tool like PsyQuation. PsyQuation can help measure a trader's performance and help with this process to optimise future trading opportunities and help traders make better decisions.
Other than that, it is also recommended for beginner traders to check out our trading education as there are a plethora of articles that help new traders understand how trading works and develop a strong trading mindset.
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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.
