Trading psychology is essential for a solid trading strategy. Many traders succumb to their emotions and do not follow their trading plan – meaning they lose money.
Having a trading plan and using technical analysis helps, but successful traders understand that trading psychology and having the correct trading mindset is the key to consistent profits.
This article will walk you through some of the trading pitfalls and how to overcome them.
What is trading psychology?
Trading psychology is our mindset and how we approach trading. It has become buzzword bingo with the use of cool one-liners such as ‘trade the trend’.
But what does trade the trend actually mean? Tell that to a beginner trader and what do they understand? It’s not actionable and unless you have learned from experience trading the trend offers little value to anyone.
It’s only when you’ve blown an account because you kept averaging down or even bought more stock to prop up the share price to stop it falling do you understand what ‘trade the trend’ means.
It’s only when you haven’t cut a loss and allowed it to wipe several months’ worth of P&L gains that you understand what ‘cut your losses’ means. We’ve all done it.
Trading psychology is more than just cliches.
It refers to the mindset a trader has during their time both in and out of the market. Trading psychology is important because our mindset determines a large part of our success in the market.
Professional traders are able to manage their emotions and stick to their trading rules. Usually, when one has a large loss we can generally track that to a specific emotion.
Traders should be able to manage their mood and emotional responses. Being self-disciplined in this way is a key skill as emotions can trip us up.
We’ll discuss some examples of emotional trading in this section…
Impatience is one of the biggest killers of retail trader accounts. Human beings are naturally impatient and they want to get rich quickly.
The desire to get rich quick, if left unchecked, will override logical thought and chase sub-optimal risk/reward trades.
I know this to be true as I have been there.
In 2017, I took oversized positions chasing big rewards and was humbled when the election saw liquidity dry up and volatility spiked to the downside. I took a large drawdown that was to be the biggest of my trading career so far.
To compound this mistake I had no exit plan because I was too busy focusing on how much profit I would make. Risk management must always come first.
This mistake continued to affect my own trading and because it increased my fear of loss and this showed in trading performance.
Anger is another emotion that can harm retail trading accounts. When a trader takes a loss on a stock he or she can feel like it ‘owes’ them.
They then want to ‘revenge trade’ the stock and allow their emotions to get the better of them.
This is similar to gambler’s fallacy – the idea that several losing results in a row increase the chances of a winning result. This is false as each trade is completely independent of every other trade. Just because you have had ten losing trades does not mean you are now due a winner.
Remember, stocks do not have emotions. Experienced traders know that stocks don’t care where you buy and sell them.
Fear also prevents us from trading optimally. This can occur because we are trading too large or because we are staring at a bigger than expected loss.
Like a rabbit in the headlights, we freeze and do nothing. This is often the worst course of action. Being scared in the stock market leaves you vulnerable to being relieved of your capital.
You need to trade enough size so that the outcome is meaningful but not so much that it leaves you scared.
A string of losing trades can cause doubt in a system and leave you trigger-shy. This means you end up missing out on profitable trades because you’re anxious about entering a trade.
It is important to remember that losing isn’t an occupational risk – it’s an occupational cost of doing business as a trader. Losing isn’t a choice, but how much we lose is always a choice.
In trading, we need to separate ourselves from our egos. There is a good chance that you have heard of this trading quote:
“Do you want to be right? Or do you want to make money?”
Wanting to be right on a trade means we have a tendency to hold onto a losing trade so that we can sell out at breakeven or a slight profit and claim that we were right.
But these trading decisions ensure that being right is an expensive hobby. Any trader wanting to produce and make money needs to lose their ego as soon as possible.
As humans, we are prone to emotional biases that play out in our trading discipline.
Here are some of the most common biases that affect our decision making and how we can mitigate them…
Availability bias is the tendency to make decisions on the most accessible information.
For traders, this means that the decision made on the trade will be done on the information that is available. The most available information, however, may not always be the most necessary.
Availability bias affects investors hard too as it means they do not go searching for difficult to find information that is not readily obtainable.
Management use the availability bias to their advantage by putting the information they don’t want investors to see hidden in the annual report. They know most investors will never read the company’s annual report.
In order to combat the availability bias, ensure you are always making decisions on the information that matters regardless of how difficult it is to obtain, and not what is readily available.
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The anchoring bias is when we use a piece of information as a point of reference, or the ‘anchor’. For example, this will often be our entry price on a trade and we will continue to use the entry price as the anchor price.
This can result in what is known as the ‘breakeven trade’.
The breakeven trade is when a trader moves their stop to breakeven so they ‘can’t lose’. This makes no logical sense because all trades should be evaluated on the price action and risk/reward ratios, not on the entry price of the position.
Trades can also refuse to cut a loss telling themselves that they will sell when the price reaches their breakeven point. This is an ego issue. Trades should always cut their losses and not use anchoring prices in their trading.
Confirmation bias is a common bias and likely to be one you’ve already heard of before.
It’s one of the biggest reasons why traders fail, and it doesn’t just occur in the stock market. Confirmation bias affects everyone in every field of life.
Confirmation bias is when we place more importance on information that confirms the beliefs we already hold. In short, we value information that agrees with us more than information we find that we disagree with.
For example, investors are likely to place high importance on a piece of news that may be immaterial. This information may be through RNS-Reach (the Regulatory News Service for non-material disclosures) yet the investor will believe that it has far-reaching implications due to the fact that the information supports their existing view that the stock is currently undervalued by the market.
Confirmation bias also leads to overconfidence and many investors will ignore or sound out bad news such as a profit warning because they believe the share price will go higher.
Traders will often visit bulletin boards in order to seek reasons for why they should keep holding and not take a loss.
This is why bulletin boards are generally best avoided. They are echo chambers where everyone is singing from the same hymn sheet, and dissenting opinions are often removed as users know enough downvotes and the post will be automatically deleted.
To avoid confirmation bias we need to accept that our brains will do our best to trick ourselves and to seek for information that agrees with our pre-existing beliefs.
By accepting this bias, we can then be aware and do our best to remain objective when viewing new information.
We have already touched on gambler’s fallacy earlier on in this article.
Gambler’s fallacy is the idea that one is due a winning trade or result after a string of losers.
This bias assumes that there is a connection between each trade when in reality there is no link whatsoever between the trades.
Just because a trader has had ten losing trades does not mean he or she is more likely to win on their next trade.
Hindsight bias is when we believe that we could have foreseen the result of a trade or an event before the result or event actually happened.
This is common in financial markets and often there will be plenty of Harry and Henrietta Hindsights to tell you that they knew after the event. However, they are seldom there to tell anyone before!
It is easy to dissect the variables of an event after the event. The causes of the 2008 Great Financial Crisis are now well known. But few people in 2005 could see that a financial bubble was brewing – if they could then it wouldn’t have happened.
A good way to protect yourself from hindsight bias is to remain objective and keep a trading journal.
Keeping a summary of how you feel before and after each trade, as well as a list of potential risks on each trade, can help us to stay on track and ensure we don’t succumb to many of the biases on this list.
Loss aversion bias
This is one of the most dangerous biases on the list.
Loss aversion is the name given to the tendency to take on extra risk in order to avoid taking a loss. This is because we feel negative emotions such as losing money twice as strong as when we make it. Therefore, we are motivated to avoid taking crystallising losses.
This is why many new traders hang on to losing trades and cut winners early. They want to avoid the pain of taking a loss. However, if the trade is showing a hefty loss then you have already lost.
One way to prevent this is to have strict risk management controls and to have either a physical or mental stop loss on each trade. A physical stop-loss is triggered if the price hits the stop loss’s price level and gets you out of the position.
Why is trading psychology important?
Trading psychology is important because it will affect every decision we make in the market.
Overconfidence can lead to excess risk and large losses, but too little confidence can mean we are trigger-shy and suffer from anxiety when it comes to placing trades.
It is crucial to be in the right mental state when trading as emotions can wreak havoc across trading accounts when left unchecked.
Before we start trading we should think about our stop loss and profit targets so that we know they are realistic and achievable. Successful trading is about building the account up slowly.
The right psychology is extremely important when making real-time decisions on intra-day trading as one bad trade can seriously derail a trading account.
How to improve trading psychology
As well as the above pointers on managing emotions and biases, here are three tangible methods you can use to improve your trading psychology and trading results.
- Points not pounds – hide your P&L
- Introduce entry and exit checklists
- Position size for optimal profits
1. Points not pounds – hide your P&L
A great way to remove emotions from trading is to imagine that you’re playing a video game and the pounds you see in your account are really points.
Getting rid of monetary symbols and hiding your P&L will prevent you from reacting emotionally.
Instead, think in percentages and this will decrease your emotional involvement in the market.
A friend of mine once ran his own global forex hedge fund and he said this was the key to maintaining composure:
“If you tell someone they’re down £5m you’ll blow their mind! But 5% down is 5% down no matter the amount”
2. Introduce entry and exit checklists
We are at our most objective when we do not have a position. As soon as we put that position on we have an emotional and financial involvement in being right.
This removes errors as I have a clearly defined plan of stocks to watch and trade, as well as assessing the risks.
When I started trading I often had the fear of missing out, or FOMO, and chased sub-optimal entries because I wasn’t making informed decisions.
I also have a closing plan to evaluate trades and performing which is available to my subscribers. Having checklists will reduce error on your part and improve your trading skills.
3. Position size for optimal profits
Calculating position sizes is the key to trading success. Many traders blow their accounts due to oversized positions.
Position sizing protects you and enables your edge to play out in the market.
In the short term, every trade is a gamble and we can’t call the outcome. But in the long term if we have an edge then we can expect to generate profits as a result of that edge in the market.
However, we need to be able to act optimally and objectively and to do that we need to position size small enough to trade without fear or ego. By knowing the amount of money we can lose on each trade keeps us from making high-risk trades.
I’ve covered position sizing in-depth in my trading handbook available to subscribers:
Developing a winning trading mindset
Top traders understand that psychology in trading and developing a winning trading mindset is important. The psychology of trading has an instrumental impact on any trader’s success.
Understanding the biases in this article and how to combat them, as well as improving your own outlook on trading and getting in the zone will have a positive effect on your trading P&L.
I’ve recorded an entire module on trading psychology (and many other trading aspects) in my UK Online Stock Trading Course. Click the link to get all the details!