What is Trading Psychology?
Trading psychology is the emotion filled aspect of trading. Anyone that has ever executed a trade knows that trading can be an emotional roller coaster. Profits keep growing, you feel great. Your money is disappearing, you feel terrible. Your thoughts are all over the place and you do not know why. Diving into the psychology of trading lets you understand your thought process before, during, and after executing trades.
Studying psychology and applying it to your trading can do wonders. Thoughts are heavily influenced by emotions. Therefore, your emotions affect your trading significantly. Wild emotions can literally make or break a trader.
The theory behind combining psychology and trading is this- if you can understand why your thoughts and emotions happen, you can alter them with a little effort. You need to control your thoughts and emotions in order to become a successful trader. Every professional trader knows this. If you want to be a successful trader, you must continue reading.
Main Components Affecting Your Psychology While Trading
All emotions in trading ultimately revolve around money. Let’s be real, the only reason why you started trading was to make money. So it makes sense that you are ecstatic when you make money and why you are so depressed and angry when you lose money. But make no mistake- profits and losses are not the only factors that play into your psychology as a trader.
You are always experiencing different emotions while trading. Your decisions are influenced by emotions before, during, and after executing trades. Here is a list of the most important factors that influence your trading psychology:
- Fear and greed
- Market Uncertainty
- FOMO: fear of missing out
- Being afraid to cut losses
- Not knowing when to take profits
Fear and Greed
Fear is what traders experience when they think there is the potential to lose money. Greed is what traders feel when all they see are dollar signs. Fear and greed are the biggest components of trading psychology.
Fear and greed often make traders do things that they regret. These emotions cause traders to rationalize the need to commit the number 1 trading sin- not following their trading plan.
Fear
Behaviors associated with fear cause traders to either lose money or pass on good trading setups because of perceived risk. Fear causes traders to exit positions too early or not take them at all, even if the setup fits their trading plan perfectly. The point here is this- fear will make traders take unnecessary losses and exit winning positions with small profits.
The irrationality created by fear is astounding.
Fear creates panic. Panic leads to panic selling. This is what makes bear markets so much stronger and financially deadly. Traders will bail out of their positions without even thinking about it if they believe that there is financial doom ahead. History shows that this thinking is irrational; panic selling is almost always followed by a rally.
Greed
Behaviors associated with greed are the complete opposite of behaviors created by fear. Greed causes traders to hold positions too long or take extremely risky plays, even if their trading plan is screaming to steer clear.
Sometimes greed can cause traders to become overconfident in their trading abilities. Believe it or not, being too confident in the market can hurt you badly.
Greed makes traders take on unnecessary risk. This is because traders want to get as much profit as they can out of a trade. Traders can get overconfident in their positions and start to believe that they will keep increasing in value despite contradictory information. If the position ends up turning in the opposite direction, greed will have caused the trader to give back their profits.
Speculative positions are also taken out of greed. Traders may jump into extremely risky positions because they think the rewards will be amazing. This is seen in traders who take part in gambling plays or lotto plays.
Trading Situations that Psychologically Trigger Fear and Greed
Understanding how psychology plays a role in the market can prevent you from falling into these traps. You will need to be able to recognize the triggers that will influence your feelings of fear and greed. Triggers come in all shapes and sizes. Trigger points depend on your personality as a trader and your trading style. For example, some traders handle risk well because their trading style involves taking on a lot of risk.
For the sake of keeping this post a reasonable length, only the most common triggers will be analyzed.
Market Uncertainty
If there is one thing that is certain about the market, it is that there is no certainty. Financial markets move in mysterious ways and it has a drastic affect on the minds of traders. Too many factors can change the sentiment of an individual stock or the whole market.
Market news brings out all kinds of emotions in traders. When news drops, traders try to digest it and react as quickly as possible. No trader wants to be caught on the wrong side of a big move. If news drops and a stock or the whole market sentiment changes, traders become either fearful or greedy and then they react.
Instead of taking the time to sit back and fully process the new market information, they decide to trust the opinion of other traders who were impatient. Traders end up getting too caught up in the excitement and make mistakes. Volatile markets are created by news playing with the emotions of traders.
FOMO: Fear of Missing Out
You see the market rallying, you know there must be a beautiful catalyst behind the move. If you take the trade here, you are guaranteed to make a massive profit. After all, no one else would be buying if they didn’t believe they’d make a profit. There is no way others would be buying without knowing the reason behind the move.
Wrong! If you are thinking this way, it is more than likely that others are having the same thoughts. When more than one trader thinks this way, it magnifies a rally.
Market rallies of this nature become over-extended and traders get trapped buying in at the highs of these rallies. The smart traders who got in before or at the start of the rally exit their positions once they see the market is becoming over-extended, trapping the new traders who bought in at the top.
Why does this happen? Market rallies create a herd-mentality. It becomes a game of follow the leader. Traders fear that they will miss out on enormous profits and jump into these rallies while completely ignoring their trading plan.
Fear of missing out is a huge reason why many traders lose a lot of money. They get caught up in the moment and think about all the money that they could be making by participating in the rally. So instead of figuring out the cause of the rally and seeing if it is overdone, they jump in to capture whatever profits are left from the move.
Logical thinking is thrown out the window. Getting fixated on a single rally is ridiculous. Market rallies happen all of the time. Sit out and wait for the next one.
Being Afraid to Cut Losses
Have you ever heard of being “married to a position”? Being “married to a position” occurs when a trader is was too emotionally attached to an open position. Obviously a trader will only execute a trade that they are confident that they will win. If a trade does not go as planned, they may refuse to admit they were wrong.
Instead of admitting defeat and moving on, the trader will try to protect their ego and “marry” their position. The end result is holding onto a loser and hoping that it eventually goes the way they originally expected it to.
They get caught up in a delusion.
Trading based on faith and hope will only leave you foolishly holding onto a position as you watch the losses mount.
Not Knowing When to Take Profits
Not having a solid trading plan or knowing key levels will leave you scrambling to figure out when to sell out of your position. It is a horrible feeling to be up a lot and not know if you should sell or hold longer.
This is the perfect moment for fear or greed to kick in. If your trading plan is not well thought out or you are unaware of where the next support/resistance level is, you will resort to using your gut.
Your trade will end one of two ways: you will sell too early and miss out on profits or you will sell too late and give back a lot of profits.
Depending on the circumstances- you may even lose money…..
Not knowing when to take profits makes being a successful trader more difficult than it needs to be.
Mindfulness in Trading
Learning to recognize how your emotions affect your trading requires a lot of effort. You need to understand trading psychology as well as your own personality as a trader. It is essential to be able to recognize what triggers your emotions while you are trading. You need a method for detaching yourself from your emotions.
Mixing mindfulness into your trading routine will improve your results significantly. Mindfulness is all about being in the moment and objectively analyzing your thoughts and emotions as they arise. Being mindful while you trade will allow you to recognize when you are experiencing irrational thoughts and emotions.
Controlling your thoughts and emotions while trading will improve your trading psychology and your trading success. Get to know yourself and get familiar with your thoughts. It takes time to master, but it is well worth it.
The More You Know, The More You Make
If you take everything from this post into consideration, you will have a good foundation for knowing what to avoid while trading.
There are many different skills and techniques that traders use to master trading psychology. The most common is to use a trading journal. Just follow the simple steps traders use to master trading psychology and you will have the results you desire.
As always, work hard towards your goals and constantly educate yourself. That is the best way to achieve success.
Do you have any strategies that you use to control your thoughts and emotions while trading? Are there other factors that you believe have a big influence on trader psychology?