Those who want to be consistently profitable in trading must not neglect the issue of trading psychology. Humans are emotional beings whose everyday decisions and actions are heavily influenced by their emotions. to succeed as a trader, we need a certain presence of mind and an awareness of our inner emotions.
What is Trading Psychology?
Trading psychology is a broad term that takes into account everything that involves your emotions when trading. Trading psychology is the study of how emotions and mental states affect traders’ decisions, behavior, and performance in the financial markets. It is an important aspect of trading success as it can help traders overcome bias, manage risk, and develop discipline.
When traders refer to trading psychology, they are normally referring to the mistakes and mental errors that they continually repeat that cost them money. These errors normally fall into two categories; errors from being greedy and errors from being fearful.
Some Trading Psychology Truths to Ponder Over
- When you lose money, it is human nature to want to make it all back twice as quickly. Slow down, keep focused, and stick to your strategy.
- If you are feeling uneasy about a trade, ask yourself the question: How would I place, manage, or exit that trade if it were to be the last, I ever placed?
- Don’t look for your trading dreams to come true, look to become true to your trading dreams. Follow your plan; follow your rules!
- You cannot predict markets on a trade-by-trade basis. But you can control yourself, and that is the key to success in this field.
- Follow your plan and not your fears.
- When you become an observer of your thoughts, feelings, and emotions instead of an actor, you will have control over your actions in the market.
- The markets can’t hurt you. Only you can.
- Without self-discipline, trading success is impossible, period.
- Do not dwell on past trades; do not dream of future trades. Concentrate your mind on the current trade.
- Keep calm while Trading. You will not be punished for your anger and frustration; you will be punished by them.
Why Does Trading Psychology Matter?
Trading psychology is important because it directly impacts the decision-making process, performance, and overall success of the individual or entity in the financial markets. The psychological mistakes that traders make are common amongst almost all traders and they can hold you back from being successful.
Traders are not purely rational beings but are influenced by a range of psychological factors that can lead to biased thinking, impulsive actions, and suboptimal decision-making. Trading psychology emphasizes the importance of self-awareness, emotional regulation, risk management, discipline, and resilience to make more objective, consistent, and successful trading decisions. By addressing psychological barriers and developing a balanced mindset, traders can improve their ability to navigate market volatility, manage risk, and achieve long-term profitability.
Feelings of greed can distract your judgment and rationality. This desire for wealth may trigger irrational investing, where you conduct high-risk investments or purchase shares without conducting proper fundamental and technical analysis. Fundamental analysis means looking at the overall economy to evaluate a stock’s value; technical analysis measures a stock’s future by looking at movements in its price and volume.
Likewise, fear is a compelling emotion that can cause you to exit markets too soon. Investors may also refrain from taking risks because of loss concerns. Fear can sometimes turn into panic, which causes the price of a security to drop without reasoned analysis.
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How Does Bias Affect Trading?
Bias is defined as a predetermined disposition of one position over another. Usually, when the trader is biased, it can hinder proper decision-making when trading because it can prevent a proper judgment. The trader may end up acting on emotions rather than on fundamental analysis.
The key types of biases that affect trading include:
- Negativity bias – Negativity bias makes a trader more inclined to the negative side of a trade instead of considering both the positive and negative sides of a trade. The impact of such a bias is that a trader could forego an entire strategy because of the negative aspect when they only need to make a small adjustment to the strategy to turn the trade into a profit.
- Gambler’s Fallacy – Gambler’s fallacy is a bias where an individual believes the likelihood of something happening becomes higher or lower as an event or process is repeated. Let’s say an investor continues to increase their position in stock despite witnessing repeated and mounting losses. This investor believes that the stock price will most likely change direction as losses continue to increase, but this mentality is incorrect. Each event is independent, and there is no correlation between past and present occurrences.
- Status Quo Bias – The status quo bias occurs when a trader assumes that old trades or strategies will continue being relevant in the current market. The danger of such an assumption is that the trader does not explore new opportunities that are relevant in the current market, and it can potentially lock them out of more viable trades and strategies.
- Confirmation Bias – Confirmation bias is another common cognitive bias where you look for, believe, or favor information that supports/confirms your pre-formulated values or beliefs. Investors may also intentionally ignore information that contradicts these values and beliefs.
- Representative Bias – If you are repeating investments for no other reason than because they previously brought you success, this is an example of representative bias. Another example is if you believe an investment is good or bad based on a company’s past performance.
How to Recognize Your Emotional Mindset?
- Recognize Your Emotions, Biases, and Personality Traits
The first thing you should do is to note how you feel when you log into an investment platform. Are you overwhelmed? Do you look for the best-performing stocks of the day and make assumptions about their future without proper analysis? Or, do you automatically check the price of a stock that previously gave you success?
Self-awareness and looking inward are crucial in trading psychology, and recognizing from the start where these emotions and biases stem from will prevent you from making impulsive decisions or acting out of frustration. It’s important to recognize your strengths and utilize them.
- Create an Investment Plan
Having an investment plan is also important in lowering the risk of your emotions causing you to behave irrationally in the market. You can work with your broker to create an investment plan or build it yourself.
- Work on Developing Positive Traits
Work on yourself by getting rid of negative emotions and personality traits. It allows you to develop new and more positive traits, such as patience and adaptiveness. Patience also comes from understanding that market volatility is normal, not personal, and time is on your side. Similarly, learning to become more adaptive is crucial in maintaining your investment plan.
- Learn when to Walk Away from a Trade
A fundamental skill in any investment is knowing when to take your losses and walk away. Just because you have lost your current trade does not mean are a failure. And most importantly that does not mean you have to immediately act to cover your losses. Use a loss as an opportunity to learn about what went wrong and then use that knowledge to make better decisions in the future.
Likewise, investors should know when to walk away after a succession of wins. One win or a few wins do not guarantee you will profit from your next trade. Your luck can run out at any time.
- Record your emotions
You can also keep a log to record how you felt during a particular investment. This will give you a good sign of what you did well or where your emotions and decision-making led you astray.
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How to Master Your Trading Psychology Skills?
- Practice With a Paper Trading Account
Paper trading can help you build confidence. Practice paper trading for a few weeks or months. Keep detailed records of your trading performance over time. Paper trading isn’t just for beginners. It’s a handy tool to return to as your skills change and grow. Use it to try a riskier trade or a strategy you’re not ready to bet real money on.
- Assume Your First Losses as a Fee for Learning
Using real money can set your trading emotions on fire! You might panic and exit a position too early when one of your holdings starts to drop.
- Observe the Habits of Successful Traders
Learn from the thousands of successful traders who are part of the trading system. Top traders spend time learning the basics. Then they work to constantly seek more knowledge and do more research. They scan stocks daily and continue to grow. Most importantly, they set goals. They scrutinize their process, trading psychology, and progress. Of course, they make mistakes, but they learn from them and improve.
- Set Stop Losses to Protect Your Account
You must set stop losses in advance. You want to keep your stop losses wide enough that a small dip won’t kick you out of a position. A stop loss also needs to be tight enough so you immediately sell when things don’t go as you expected.
- Choose Your Favorite Patterns and Stick to Them
Looking for patterns is a big part of trading psychology. Patterns tend to repeat, so identifying them can help you in your trading.
But you have to find what works for you. Pick two to five of your favorites. Practice recognizing when they occur. Back in the old days, I kept binders full of charts so I could review them as often as I needed.
- Learn How to Properly Read News Catalysts
News catalysts are important and must be taken into account. Most people read a news story and assume that the news will be a catalyst. But by the time you read that news, so has every other trader. And they’ve already acted on it. A smarter approach is to do the opposite. Use a stock screener to check out stocks first. Then look for a news event to explain a stock’s performance.
- Use a Stock Screener to Locate Your Best Stocks to Trade
A watchlist can help you focus on specific stocks that meet your needs. You can set your requirements based on your strategy for the kinds of stocks you want to monitor. Stock screeners can filter through thousands of stocks to help you find companies you want to trade. Then you can focus on those that meet your criteria.
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Trading Psychology Mistakes and How to Avoid Them
Trading in too much confidence can hurt your account. Overconfidence can lead to investors taking too much risk which can ultimately result in significant losses.
In order to avoid the consequences of overconfidence in trading it is essential to have a trading plan and more important to stick to it. Don’t let your emotions take over and make impulsive decisions.
- Running on Hope while trading
Trading while hoping that the trade will work out is another trade psychology mistake investors make. No doubt staying positive is an integral part of trading but traders should be able to draw the line between a realistic approach and an arbitrary approach based on mere hope.
Don’t let hope cloud your judgment and lead you to make irrational decisions.
- Expecting Perfection
Nothing is perfect in the real world. And no trade is perfect in real-time in the stock market. Therefore, expecting your trades to provide perfect outcomes every time is another major trading psychology mistake investors make.
It’s essential to accept that losses are a part of trading and learn from them. Don’t let the fear of failure prevent you from taking risks.
- Needing to be right
The driving force of needing to be right can lead to disastrous results. It can lead to holding onto losing trades for too long.
It’s essential to cut your losses short and move on. Don’t let your ego get in the way of making smart trading decisions.
- Analysis Paralysis
Analysis paralysis is the state of over-analyzing a situation, which can lead to indecision and missed opportunities.
It’s essential to have a trading plan and stick to it. Don’t let analysis paralysis prevent you from taking action.
- Underestimating the Process
A lot of traders when they’re starting out expect to be the exception to the rule that says that not all trades are going to be profitable and you will not become an overnight millionaire.
Don’t underestimate the process. So expect to have good and bad trades.
- Don’t get too emotionally involved
Getting too emotionally involved with a trade would mean that you’re not thinking with your mind anymore but your heart.
Learning to remain objective ensures that you make intelligent decisions. Emotions can shade your judgment.
- Calculating profits before even entering the market
Entering the market with the mindset that you will earn a specific amount of profit on a particular trade is very harmful. Because chances are you will not earn the amount of profit you have estimated.
The market is unpredictable and losses are inevitable. So don’t go in with high expectations to the point that you get disappointed and lose faith in your trading skills when you’re not able to reach that profit.
- Expecting to make money every single day
That is not a sustainable hope. You can aim for a weekly or monthly income overall, but hoping to make something every day will throw you into a downward spiral.
It does not happen for anyone this way. So, don’t keep such expectations from yourself.
- Being Overcautious
Being extra cautious will lead to traders missing out on potential losses. This way your portfolio will not get enough time to grow.
Don’t be overprotective of your trade. Worst scenario you will not earn profit.
- Not being cautious
Not every trade will go high and not every trade will go low. Don’t stay in a trade for too long hoping to become rich off of that one position.
Finding a balanced approach is very important, where you allow for some profit (and potentially some loss too) while also ensuring you’re not setting the ‘take profit’ bar too high.
How to get better Control over your Emotions while Trading?
- Clear your mind – In trading, you need to be able to focus on lots of data in a fast-moving market. You can’t allow other things to distract you. Always be mindful of your mental state and don’t let external factors disrupt your mind during trading.
- Visualize your trade – Before investing your money visualize your trade in your mind. And with it imagine different outcomes: you win, you lose, and/or break even. And understand how every situation made you feel. This will prepare your mind for every possible outcome and help you overcome emotional decision-making later on.
- Know why you trade – This is very important to identify and remind yourself continuously. Whether it’s side income, money for retirement, or for college funds. Knowing why you are in the business of trading is the key motivating factor that keeps you on track.
- Make your trades real – Since trade is not exactly a hand-to-hand exchange of cash with stocks, the real feeling of a transaction seems to be missing. In order to make your trades real, maintain some visual cues for every trade. Like, put a dollar bill for every $ 100 you invest in the market.
- Keep a journal – Keep track of all your trades by maintaining a trade journal. Write about your emotions before and after your trade. This will help you evaluate your decisions whether they were emotional or rational.
What is the Right mindset for Trading?
Your mindset can make a huge difference to your trading success. Always approach the market with a neutral mindset.
- No Second-Guessing
Don’t second-guess yourself. Stick to the rules you’ve set for yourself and the trades that are proven to work for you.
If you start doubting or second-guessing yourself you have fallen into the trap of emotional investing which leads to disastrous results.
- No Regrets About Bad Trades
Don’t look at every loss as a failure — see it as an opportunity to learn.
Don’t regret your losses. But identify what went wrong and try to avoid it in your future trades. Even the most successful traders make mistakes. They don’t regret their trades and put a pause. They try to cut short losses and move ahead with a new lesson every time.
- There Is No Perfect Trade
No one wins 100% of the time. You will lose money in the majority of the trades.
It’s better to exit a position with some success than to risk a loss trying to get a bit more. Accept that you’ll never be perfect and you can save a lot of time and money in the long run.
- Commit to Learning Forever
The stock market is constantly evolving and changing. Therefore, traders have to change and evolve with it too. Embrace the changes: the new technology, new tools, screeners, indicators, and every change the market undergoes. This will help you sharpen your skills and give you an edge.
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Investing is an emotionally driven activity. And if you let your emotions take control of your decisions it can have negative effects on your portfolio. A compromised decision-making process can determine your success or failure in investing in securities
Psychology is a huge part of trading stocks. The better you understand your mental and emotional patterns, the better you’re likely to do. Set your rules ahead of the trade. Plan your entry and exit. Stick to the plan. And remember to practice.
One of the most common emotions associated with trading psychology is:
Some of the most common biases include:
- Confirmation bias
- Representative bias
- Status quo bias
- Gambler’s fallacy
- Negativity bias
There are different ways to improve your trading psychology, such as recognizing your emotions, creating an investment plan, developing healthier personality traits, and learning when to walk away.
Summarizing the trade tips here:
- Don’t risk too much on any one trade.
- Don’t chase your losses with revenge trades.
- Don’t over-trade and make too many trades.
- Don’t let the last trade stop you from making your next trade.
- Always cut your losses short at your stop-loss point.
- Always take profit at your designated profit target level. Don’t get greedy and hold for more.
Emotions have no place in trading and that balance is key. The aim should always be sustainable trading and continuous profits. For this, you need to keep your hopes and fears in check and instead employ information and logical thinking as your primary tools.
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