Refers to the unique psychological characteristics of an individual that influence their trading decisions
"Investors need to keep their emotions in check for a successful investment career. It is the most important requirement. It's even more critical than having access to capital and markets."
― Naved Abdali
What is trading psychology?
The trading psychology of an investor refers to the emotional and mental health conditions of an individual that impact their trading decisions.
These emotions can have either a positive or negative impact on decision-making depending upon the kinds of emotions that are rushing inside the individual.
It can be easily understood as the mindset that a trader has while trading. It is different for everyone. This type of psychology is representative of the individual's behaviors and character.
It is crucial when determining the success of any trading decision and holds value equivalent to the knowledge possessed by an individual, their experience level, and the skills they have accumulated in the process.
Two of the most crucial aspects of this concept are discipline and risk-taking. These are often associated with specific emotions that act as catalysts for trading. Traditionally, only two emotions were attached to trading; greed and fear.
Greed can be easily described as an excessive desire for wealth, clouding rationality and judgment. Thus, a greed-inspired investors often make very risky decisions, putting their money at risk.
On the other hand, fear dictates an individual's mind in the exact opposite manner. A fear-stricken investor tends to refrain from taking even a negligible amount of risk due to the concern of huge losses.
This can restrict the investor's returns as they may irrationally exit the market. Panic selling is a result of fear in the mind of the trader.
Let's understand trade psychology through an everyday example.
An average investor tries to stay away from losses as much as possible and gives their best to make profits as soon as possible, i.e., they give a greater priority to avoiding losses than to maximizing the possible gains. This is commonly known as "loss aversion."
Importance of Understanding Trading Psychology
The fear of losing money and making mistakes is one of the most difficult obstacles for every trader to overcome.
Unfortunately, taking risks that could result in losses is unavoidable while trading. Loss aversion includes the fear of missing out on something important.
To combat this, a trader must approach their trading activity in the same way that a business is managed. Focusing on numbers and referencing facts while avoiding emotions from influencing trading decisions is a solid strategy.
Beginner traders should think about incorporating this habit into their trading mindset before making their first deal.
It's more about how you learn than what you learn when it comes to improving your trading technique. As a result, the need to stick to a routine is reinforced, as it is crucial to learning and comprehending how to trade properly.
The following pointers can help one better understand the importance of mastering trading psychology:
- Quite often, traders are tempted to make quick/snap decisions, especially in situations when the market is volatile. They have to make decisions regarding the buying/selling/holding of shares.
Due to a lack of time and a lot of pressure, traders sometimes make errors, leading to losses. Thus, traders should make some rules for themselves, which they can abide by in such situations, hopefully leading to greater profits.
- Hearing unfavorable information about the market/economy can create fear in the mind of an investor and lead them to make decisions under duress. Understanding trade psychology allows one to access the market properly without making any big decisions in haste.
- In situations where an investor holds on to a winning position for too long, with an expectation to earn even a higher amount of profit, they may actually end up in a losing position. Thus, proper management of one's own greed is crucial.
How important is this concept?
To make one's trading journey successful, one must take steps to understand their behavior and take action to correct it. If we continue without an assessment of our psychology while trading, we may end up not achieving the greatest returns.
Thus, to witness a positive trend in our income from trading, it is crucial that we properly assess our trading psychology and observe our patterns. A proper trading plan must be put into place once all the assessments have been made.
The personal disposition of an individual to favor some things over others can hinder decision-making skills. These dispositions are commonly known as biases, and they often cloud judgment.
Biases can be divided into five major categories:
1. Representative Bias: You will cling to or be more tempted to duplicate prior successful trades when you have representative bias. You may do this without research simply because it has worked for you in the past.
2. Negativity Bias: Negativity bias makes you more likely to focus on the bad aspects of a trade rather than the positive aspects. This may mean that you throw out an entire approach when all you needed to do was adjust it a little to make a profit.
3. Status Quo Bias: Under this kind of bias, you normally continue to use existing methods or trades rather than trying newer ones. The issues arise when you don't check whether those old tactics are still viable in today's markets or not.
4. Confirmation Bias: This kind of bias exists when you give greater weight to news and analysis that supports your pre-formed opinions. It's also possible that you don't seek out or ignore information that contradicts your beliefs.
5. Gambler's Fallacy: The gambler's fallacy is when one believes that something that has previously happened frequently will now be less likely to occur. For example, believing that since the markets have been going down for a while, it is less likely they will continue to go down.
Read more about the concept and the related emotions here.
Curbing Emotion-Driven Trading Decisions
First and foremost, you must identify emotions to be able to avoid emotion-driven trading.
Whenever an investor trades, they must consciously identify and analyze the emotions that arise when they find themselves in a certain situation. The first step to effectively managing such emotions is knowing how we normally respond to them.
Trading is primarily based on one's instincts, but it is better if these instincts are supported by some real facts and figures. This leads to better decisions and decreases risk.
One should keep track of the times when their trading decisions were purely based on their emotions and had little or no dependence on market trend analysis.
The next step is to observe a pattern in such decisions and analyze the situations under which you made such decisions.
Next time, the investor must take corrective actions to either eliminate or avoid such situations. This is so that most of their trading decisions will be based on conscious thought with real backing rather than emotions.
A proper risk management plan must be formulated, laying down rules or steps that define when a profit or loss should be booked to avoid further risk. This will help to maintain discipline while making trading decisions and keep check of one's own actions/decisions.
This will eventually reduce the percentage of decisions that are emotional in nature.
Losses will also decrease over time if an effective risk management plan is put in place and followed.
If you don't trust in your method and skill and stick to a consistent plan in everything you do, you won't get very far, not just in trading. After being clear and transparent about your trading rules and method, move forward.
We may change our rules when swayed by the opinions of others. This must be avoided at all costs.
Opinions are crucial, but only if you do your homework and understand counterarguments. It is not prudent to rely on them merely because they appear to be intriguing.
When it comes to trading, relying on the opinions of others can be dangerous. Avoid listening to other people's opinions (if they are baseless) if you wish to trade with confidence.
Tips on avoiding emotional trading
Following are the tips:
1. Identification of personality traits
When an investor's emotions start taking control of their mind while trading, it is critical to keep these characteristics in check. If this isn't done, it can lead to impulsive and ill-advised decisions with little analytical support. It's crucial to play to your specific talents.
2. Development of a trading plan
A personalized trading plan can often act as a rule book for the trader, which must be abided by in all situations. This can help with reaching goals.
A plan lays down various criteria that have been created by the investor themselves. Having a trading plan can aid in shrinking risk and limiting the effect of emotions on trading.
It basically adds discipline to one's trading journey.
3. Having patience
Patience is a prerequisite for discipline. When you act on emotions like fear, you risk missing out on a profit by closing a position too soon. Be confident in your analysis and be patient and disciplined.
Likewise, when trying to enter a trade, it's vital to be patient and wait for the proper opportunity rather than leaping into a position straight away.
4. Being Adaptive
You should get used to judging how the markets change from day to day and learn to adapt accordingly. If the market becomes more volatile on a given day, you may decide to put a halt to your trading activity and try to understand what's going on.
Adaptability can help you control your emotions and eliminate representative and status quo biases, allowing you to judge each scenario on its own merits and stay realistic while trading.
5. Taking breaks after incurring/gaining a loss/profit
After incurring losses or earning huge profits, it is always advisable to take short breaks and analyze the activity properly. It is inadvisable to run into a fresh trade right after taking a loss to recover from it.
During this assessment period, emotions like pride and fear should be kept aside, and an accurate judgment should be made, acting as a learning experience for the next time.
6. Maintaining a trading log
A trading log acts as a register and helps a trader keep track of all their trading activities. Whenever they buy or sell a particular commodity, they must make an entry into the log. It can be effectively used to analyze profits/losses.
How to improve your trading psychology
The ability to create and hone one's trading psychology is linked to performance since it allows a trader to remain calm in stressful market circumstances. Sound judgment will triumph if you gain a strong knowledge of the errors that may develop.
However, doing so is difficult since traders might make extremely subjective assumptions. Looking at data and using a tool is always more beneficial.
Traders can enhance their mindsets while trading by recognizing their own emotions, biases, and personality qualities that might influence the success or failure of a trade. This can be done using the following methods:
1. Developing the correct mindset
Simply remind yourself that markets are never constant before you start your trading day. There'll be good days and bad days, but the bad days will still pass.
Giving yourself enough time is another great method to improve your trading attitude. You're unlikely to create a fortune on your first day of trading. You want to devote time and energy to developing a rock-solid trading technique that's unaffected by market conditions.
While emotions can never be totally removed from trading, the idea is to limit the extent to which emotions control your trading mindset.
2. Having a dependable mindset
Increasing your knowledge and trading skills is amongst the most effective strategies to boost your trading mindset. To beat negative trading psychology, you will need a solid understanding of the stock exchange. Remember, information is power.
Traders should spend adequate time studying and assessing opportunities before investing in a stock, technology, derivatives, etc. One must follow the news, study, read trade journals, and conduct research.
Traders should participate in webinars, trading seminars, and conferences whenever feasible to find out from and interact with other traders and finance professionals.
3. Don't forget that it's real money
It's easy to forget that the figures on the screen reflect real-time money when you're trading. There's nothing wrong with taking a risk with your money in the hopes of creating a profit.
However, remember to use caution and make informed financial judgments, as an incorrect decision can have a severe negative impact on your wealth.
4. Learn from the experts
The securities market is unusual as each trader is treated differently. When trading, it helps to remember what your peers do so you'll learn from them instead of duplicating them.
You can improve your trading tactics by examining the positive aspects of successful traders and incorporating those habits or strategies into your own trading.
5. In the end, practice is the key
Last but not least, practice is the simplest and most consistent technique to enhance mental strength. It aids the development of your trading psyche, as you develop well-practiced trading techniques and are well prepared for any ups and downs.
If you simply continue learning trading skills theoretically, without applying your learning within the markets, you'd never be able to excel. You learn the most effective when you practice.
In the end, we would just like to say that the whole process of understanding, learning, and implementing trade psychology is a bit complex and time-consuming. However, if you persist and are consistent, you will be able to master it in no time.