If you're reading this, there are 100s of emotions troubling your trading activities, and you have realized the psychology of trading is one of the most crucial aspects of trading.
Successful trading is neither magical nor mysterious. It is the natural consequence of consistently applying the simplified trading approach.
But most traders face a tough time deploying one trading system in the long run as emotions take over a logical mindset. Hence, trading psychology is equally important as compared to technical analysis and money management.
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What is Trading Psychology?
Psychology means the mental factors or emotions governing a situation or activity in a person.
So, when we say trading psychology, it implies cognitive factors governing trading.
In simple words, trading psychology is all about the thoughts, emotions, and feelings a trader encounters while trading.
As compared to any animals, human beings have two additional qualities – 1) Vivid Sense of Memory and 2) Imagination.
When we don't have control over these two aspects, we get many life problems (and in trading). Lack of control over these two aspects is the main reason for all our problems in life.
Do you agree?
Scenario 1 - A trader buys some shares of a company. The price starts going upside. Every day holding this profitable trade is a difficult task for him.
So, one day he sells all the shares and makes some profit. The price moves further on the upside in the next few days.
Scenario 2 – A trader enters a trade when the price is at 100. He thinks 95 is the stop-loss for his trade. The price starts moving upside for some time. Later it starts trading between 97-99.
He thinks it is a good trade and needs more cushion; hence he pushes the SL of the trade to 93. To cut the story short, he keeps trailing the stop-loss on the downside until he makes a significant loss.
Scenario 3 – A trader is confident in a trade. He takes the position as per the rules of his trading system.
The price starts moving in the expected direction. At that exact moment, he came to know that one famous trader had taken a trade on the opposite side in the same stock.
Now he thinks he is a renowned trader, and hence he is definitely right. So, he closes his trade. But the price moves in the expected direction and reaches the original target.
Scenario 4 – A trader has done detailed backtesting of a trading strategy.
He defined all the rules for his trading, including money management and position sizing. He starts to make decent profits every day using his trading system.
But one day, he saw a tweet from a Twitter trader who had made massive chunks of money in one day.
The next day, he wants to make the same amount of money (similar to the Twitter trader) and take a massive position.
Unfortunately, markets take his stop-loss, and he loses all his profits.
I am sure most of you have gone through these kinds of situations. Besides, we can list some more scenarios.
However, I want to highlight two crucial aspects:
The existing trading psychology caused all the issues as mentioned above
All these issues again complicate the trading psychology files in our subconscious mind
Do you agree?
How to Improve Trading Psychology?
The below points will help:
Take a break from trading for a few days if you lose big money.
Improve your conviction by doing thorough backtesting.
Use 1-2 trading strategies.
Follow money management rules.
Don't look at other traders' profit screenshots.
Meditate every day for 30 minutes.
Four primary emotions revolving around stock market trading are greed, fear, regret, and hope.
A trader has to log all his trades, and when he analyzes all his failed trades, the reasons will appear automatically.
Greed
Most people come to the stock market intending to make money. Well, this is not wrong. But most traders set high expectations from the market and that too in quick time.
Trading is like any other profession, demanding focus, dedication, and hard work from traders for some time.
For example, a trader makes Rs.1,000 from one intraday trade with a capital of Rs. 1,00,000. But he feels the profit of Rs.1,000 is a minimal amount to feel good.
However, what he doesn't realize is Rs.1,000 is 1% returns on the capital in one day, and repeating the same success for 1 month gives over 20% of returns on the capital.
If he progresses at the same pace, he can double the capital in 5-6 months!
But many traders don't calculate the returns on a % basis on their capital. Hence, they end up taking big position size or many unwanted trades to lose a massive share of the capital.
A trader can survive in markets without profits but not without capital. Protecting capital is pivotal, and the next important aspect is consistent profit-making.
Solution – If you are a beginner, never enter the market to make quick money.
One can get more opportunities when you get into a lower timeframe, but the noise is also high.
A person can start with higher timeframes trading, such as swing trading, price action trading, or investment in the beginning. Once he understands the market, then he can get into lower timeframes trading, such as intraday trading or scalping.
Fear
Most of the fears in our minds are created from our past bad experiences in trading.
For example, you are ready to take a breakout trade. But your mind hesitates to pull the trigger; it means you have lost money with some breakout trades in the past, and your subconscious mind has stored the breakout trading concept with pain. Hence, there is hesitation in your mind.
In some cases, fear also occurs due to your upbringing.
For example, if you have absorbed the thought that business is bad while growing up, then you face many difficulties in your trading.
Solution - The only way to eliminate fears in trading is by increasing the conviction in trading. You can do this by backtesting your system with more data, reading specific niche books on trading, or taking a particular Trading course.
If you have any fears related to your upbringing, then identifying and acknowledging them is the most critical step. Then you can use simple methods such as affirmations or practicing gratitude to get rid of these fears. If the issue persists, you can consult a mental coach or hypnotist.
Regret
In trading, our regrets are never-ending. If you exit a trade and the price keeps moving in a favorable direction, you regret your exit decision.
If you don't take profits from one trade and then the trade takes a turn into the negative zone, you will regret your decision for not exiting.
Solution – Plan your trade and trade your plan. Please note it is not possible to catch all the good moves in the market. Focus on learning and improving day by day, trade by trade.
Hope
A trader starts hoping for some miracle to happen as soon as he deviates from his trading plan.
For example, a trader plans to buy a stock at 200 with 198 as the Stop loss level and book profit at 204 level.
The price moved to 200, and he is in the trade.
After some time, the price moved to 204, but he didn't book profit as he started hoping that short covering would come into the market anytime and it would take his position to massive profit.
Now the market has taken a U-turn. Our stock price moves back to 199, and now he starts to hope for a rebound.
The price falls below 198, but he doesn't book the loss as he thinks a rebound is just around the corner. The price is now 196, and he is still hoping for a rebound.
What has happened in the above example is that he has lost control of his trading plan.
Pre-decided stop loss and target are the two points where we need to act.
Once we do not reach those points, the situation is not in our control, and the decision we take after that is based on hope, which is a sign of weakness.
Solution – Be ready with action points (Stop loss and target) and act as per your trade plan. The market keeps throwing many good opportunities. Please don't allow any trade to be dependent on hope and then become hopeless.
Trading Psychology Quotes
There are many quotes on trading psychology. But I am listing only some of the important ones. Please read carefully:
"The human side of every person is the greatest enemy of the average investor or speculator" – Jesse Livermore
"Why do you think unsuccessful traders are obsessed with market analysis? They crave the sense of certainty that analysis appears to give them. Although few would admit it, the truth is that the typical trader wants to be right on every single trade. He is desperately trying to create certainty where it just doesn't exist." – Mark Douglas
"It was never my thinking that made the big money for me. It was always my sitting" – Jesse Livermore
"If most traders would learn to sit on their hands 50 percent of the time, they would make a lot more money." – Bill Lipschutz
"Successful trading is always an emotional battle for the speculator, not an intelligent battle" – Jesse Livermore
"All you need is one pattern to make a living" – Linda Raschke
"If you can learn to create a state of mind that is not affected by the market's behavior, the struggle will cease to exist." – Mark Douglas
"Patterns repeat, because human nature hasn't changed for thousands of years" – Jesse Livermore
Trading Psychology Books
We have many books on the stock market, and very few books focus on trading psychology.
Below are some of the good books on the psychology of trading:
(All are paid links)
Trading Psychology 2.0
Do you know when a trader takes the trade, there could be only 5 possible outcomes? Below are the 5 possible outcomes for any trade:
A breakeven
A small loss
A small profit
A big profit
A big loss
If a trader gets rid of all the 'big loss' scenarios, he will stay in the market. Isn't it?
Now the question is how to identify such big loss cases?
Pareto's 80/20 principle will help us. The law is simple, and it says, '80% of the results come from 20% of the causes'.
In simple words, a trader will have 2-3 fundamental issues associated with him, which results in over 80% of the losses in his trading.
Below are the main reasons which bring over 80% of the losses in the trading (in the same order):
Revenge Trading
Eagerness to trade every day
Wrong position size
Revenge Trading
Every trader agrees that revenge trading is the main culprit in their trading.
Sometimes, traders make unnecessary trades either because of boredom or intend to make some trades and lose money.
It hits their ego (unconsciously), and they end up taking more trades in the second half, which gives a big blow to their capital.
Eagerness to trade every day
Many traders think taking some trades every day is like a ritual aspect of their trading. But that is not always the case.
Sometimes, the market waits for some fundamental information, and it doesn't show moves in any direction. Participating in such market days is a suicidal act that can result in revenge trading later.
Don't forget this famous quote by Jesse Livermore – "There is time to go long, time to go short, and time to go fishing."
Wrong position size
Most of traders don't realize the importance of position sizing until they blow off their capital!
Once again, the logic is straightforward.
Assume a trader risks 10% of his capital in one trade.
Then even if he has a good system with more accuracy, there is a possibility that he can get 5-6 failed trades in one stretch. Isn't it?
Then what will happen to his capital when he faces 5-6 losing trades in one stretch?
Besides, how will he feel after losing over 50% of the capital? It leads a platform to commit more mistakes. Do you agree?
How to make trading decisions with fewer emotions?
The below inputs are helpful in avoiding emotions in trading.
One Trading System
When you drive your car to a known location (office to home or vice-versa), do you use GPS? Or do you think consciously about the turns you have to take or about the traffic?
No, right?
It is part of your routine, and the route map is crystal clear in your mind.
Similarly, when a trader gets a high conviction in one trading system and takes trade practicing all the defined rules, it will be wired in his subconscious mind. Hence, after some time, it leads to fewer emotions with trading.
Algo Trading
If a trader has a backtested trading system with a positive edge, and if he can define all the rules for entry, stop-loss, exit, and position size, he can opt for algo trading to avoid any emotions in the live market.
Some benefits of algo trading are:
High execution speed to place the trades
Zero human error
Less screen time
Algo trading alone is not the final solution for all trading issues. Even switching off/on an algo on some days is also emotionally challenging.
Besides, a trader has to do some extra work like coding the strategy, backtesting, and connecting the algo terminal to a trading account. Also, there will be some recurring monthly expenses to run the algo.
Meditation
Take it or not, none of us can escape from stress. It increases the heart rate and breathing, and due to this condition, our adrenal glands overproduce cortisol hormone in the body.
If a person's body is overexposed to this hormone, it will have an adverse impact on the brain and immunity of the body.
In this condition, making better decisions in the live market is not easy.
Successful trading is all about making decisions. Isn't it?
Getting rid of the root causes of our stress is difficult, but we can minimize its impact on our bodies and mind. Meditation helps us to reduce the negative energy in the body and mind.
In the beginning, one can start with 5 minutes or 10 minutes to meditate; make it a habit. One can sit in a chair or on the floor with a back erect. Close your eyes and breathe slowly. Observe your breath for some time. Slowly extend the practice to 30 mins to 1 hour every day.
Did you like the article? If yes, please share with your friends who are struggling to know the psychology of trading.
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