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The Role Of Psychology In Trading
Alex

LEVEL 10 : SENIOR

REVIEWS 9 | REPLIES 84

#2017

Alex

September 11, 2015 at 2:40 pm

Traders require numerous attributes and abilities for them to be successful in the financial markets. The most troublesome issues we confront as traders are the ones that we don’t even know exist. Certain human inclinations influence our trading, yet we are often completely unaware that they are affecting us. A major slip-up that newbies make when first figuring out how to trade is to expect that developing technical or fundamental analysis skills alone will allow them to become a successful trader. Truth be told, figuring out how to control emotions is the most critical skill a trader could develop to become a successful trader. When trading in a technical way, we can see where we have failed and attempt to fix it for our next trade. When we have a solid trading plan and are still losing cash, we have to take a gander at ourselves and our psychology for a solution to the problem.

The Role Of Psychology In Trading

Trading psychology refers to the aspects of an individual’s mental makeup that dictate whether he or she will be successful in buying and selling securities to make a profit. Discipline and risk-taking are two of the most critical aspects of trading psychology. A trader’s implementation of these aspects is essential to the success of his or her trading plan. Fear and greed are the two most commonly known emotions associated with trading psychology; other emotions that drive trading behavior are ego and regret.

trading-emotion

Greed is when people have an excessive desire for wealth. Greed is your worst enemy. When a trader experiences greed, it means that they try to go for too much profit and deviate from their trading plan. This causes traders to take on larger trade sizes than what they normally would. There’s an old saying on Wall Street – “pigs get slaughtered.”

Fear is simply a natural reaction to what individuals perceive as threats. Fear causes traders to refrain from taking on risk because of their concern for losses. This means that they avoid making trades altogether or use smaller trade sizes than what they should.

Regret may cause traders to take a trade after initially missing out on the best entry according to their trading plan. This is a violation of trading discipline and will more often than not, result in the trader getting in too late. Regret may also cause traders to revenge trade. Revenge trading is when a trader chases the losses they have made. They are so focused on winning the money back which they have lost that they fail to realize they are not trading with a set of rules anymore. Each trade ends up resulting in another loss.

A trader affected by their ego does not want to admit they are wrong. When traders take a loss on a perfectly valid trade, they will not go on to search for the following setup per their trading plan. Instead, they continue making trades based on their original analysis because they believe that they were right in the first place. Ego can bring about a whole string of losses if you can’t control it.

Successful trading is determined by many trades and not just any one single trade. This implies that a trader must be disciplined enough to adhere to the rules of their system without letting emotions get in their way. This is not as easy as it sounds because we, as human beings, often do not behave in a logical way. There are many times that emotions will influence us, and we act differently to normal.

Do you recall the last time you were furious about something? Perhaps you did something and you were surprised by your actions that you took. As much as you thought twice about it thereafter, at the time you most likely couldn’t help it. Besides, you are likely to act the same way again if you are in a similar situation. This is because the psychology of an individual is made up of thoughts and feelings that are an incitement to act. Psychology shapes our behavior in every aspect of our lives – trading is no exception.

Emotions are inescapable particularly for a newbie trader. They can keep you from making an objective decision. Thus, figuring out how to control emotion becomes paramount to successful trading over and above everything else.

The importance of discipline when trading

You will need to build discipline that will allow you to think as objectively as possible in order to avoid emotionally influenced trading. There are a few ways in which you can achieve this:

  • Using a proven strategy:

Traders are much more likely to remain calm if they have confidence in their trading plan. If the strategy has not been tested enough times, it may lead to doubts that could allow fear to impact the trader.

  • Demo account trading:

Testing your strategy on a demo account will help you build confidence in your trading plan. This should allow you to keep calm when you are under pressure.

  • Decrease your risk:

Using real money will create additional pressure that will likely amplify negative emotions that are involved when trading. This is why it is a smart idea to start with the minimal trade size until you can learn to control your emotions.

  • Accepting the risk:

Traders should be prepared to take losses. A strategy with a 100% winning ratio is unrealistic. It ‘s okay to hope that all trades should turn out as winners – nobody likes losing. New traders are likely to experience a stronger emotional impact when they take a loss compared to experienced traders. Professional traders are able to accept losses as part of trading. They can move on to their next trade without allowing greed or fear to affect their future trading decisions.

When a trader is thinking clearly without any influence from emotions, they are said to be “in the zone”. When you are in the zone, you can control your feelings and are able to trade in a logical and systematic way. Some traders find it easier than other to get in the zone, but even those who struggle can learn to control their actions and become emotionally detached from trading.

The 14 Stages of Trader Emotions

Trading psychology can be a roller coaster ride for most traders. Knowing that we can never conquer our emotional biases, we must learn to understand the scope of emotions we may encounter as traders, and how it will influence our interaction with the financial markets. There is a common market psychology cycle that exists, which explains how emotions develop and the impact they have on our decisions. Having the knowledge of this cycle, we can tame the emotional roller coaster. The figure below is a visual representation of the 14 stages that I will cover below.

investor-cycle

  1. OPTIMISM – It all begins with a positive outlook or a hunch leading us to buy or sell.
  2. EXCITEMENT – Things start moving our direction, and we begin to envision what our market success could hold for our future.
  3. THRILL – We feel “smart” at this point because the market keeps on being favorable to us. We will have complete confidence in our trading system.
  4. EUPHORIA – This is the point of maximum financial risk and financial gain. Our trading turns our investments into quick and easy profits. We begin to ignore the fundamental concept of risk and expect every trade to become profitable.
  5. ANXIETY – The markets starts to turn and takes our “hard earned” gains back. We tell ourselves that all our ideas will eventually work so we stick to the plan.
  6. DENIAL – The markets don’t do as we had hoped. There must be something wrong, we think to ourselves. We deny that we made poor choices and think that things will improve shortly.
  7. FEAR – Reality sets in – we are not as smart as we once thought. Confidence in our trading plan starts to fade.
  8. DESPERATION – All gains have been lost at this point. Not knowing how to act, we attempt to do anything that will bring our investment back to breakeven.
  9. PANIC – This is the most emotional period by far. We have exhausted all ideas and are at a loss for what to do next. It feels like we have no control over what will happen.
  10. CAPITULATION – We have reached our breaking point, and we settle for what we have left over.
  11. DESPONDENCY – After exiting the markets, we feel as if we never want to trade again. We think that the markets are not for us, and we should avoid it like the plague. However, this often marks the point of maximum financial opportunity.
  12. DEPRESSION – Not knowing how we could be so foolish, we are left trying to understand our actions. Some start to look back and analyze what went wrong. This is where real traders are born when they learn from their past mistakes.
  13. HOPE – Eventually we come to the realization that markets move in cycles. We begin looking for our next opportunity.
  14. RELIEF – Having made a profitable trade, we regain our faith in our ability to grow our investments. The cycle starts all over again!

Traders clearly follow this cycle in their decision-making process. That is why we should expect markets to track this pattern as well. If we can identify the stage of the cycle we are experiencing, we will have a greater grasp of how our emotions are affecting our trading decisions. This knowledge will also help us understand how other traders might be thinking, so we could use it to our advantage.

Conclusion

Now that we know that an individual’s psychology plays a huge role in his decision-making process, it is important for us, as traders, to be able to keep these emotions under control. In order to overcome these mind matters, you should set yourself some trading rules, build a trading plan, do lots of research and get all the necessary experience. There will be times that emotions will have a bigger impact on you than normal, but the important part is to be disciplined and follow the rules and guidelines that you have set. Print some of them and stick it on the wall to remind yourself what you should do.

Earle Crozier

LEVEL 1 : NEWBIE

REVIEWS 7 | REPLIES 2

#2072

tazzz

September 15, 2015 at 9:01 pm

Oh man I am guilty of being one of the greedy ones. I make some profits for the day and then I give it all back, because I want to make more. I will try your suggestions in this article to see if I can overcome this problem.

Regards

Garrett Nagao

LEVEL 1 : NEWBIE

REVIEWS 7 | REPLIES 1

#2073

Garrett

September 15, 2015 at 10:16 pm

I think that psychology definitely plays the biggest role in any person’s trading. It becomes harder to keep your emotions under control when you start trading with bigger amounts. Every time I get in to a trade I get a sense of fear. But I must say that it gets better after you have taken a few trades. At least I am not the only one struggling with my psychology

Garret N.

Moises Mease

LEVEL 1 : NEWBIE

REVIEWS 7 | REPLIES 2

#2074

number1options

September 16, 2015 at 5:08 am

Cool article Alex! I have a question though…. How long should one trade using a demo account to switch over to live trading?

Thank you

Alex

LEVEL 10 : SENIOR

REVIEWS 9 | REPLIES 84

#2081

Alex

September 16, 2015 at 2:06 pm

Hallo Moises,

This is a very difficult question to answer with a definite time span. Everyone has a different set of emotions and use different trading styles. Some will succeed much earlier than other. You should focus on winning consistently and become used to taking trades without thinking about them. This will only be achieved through sufficient practice.

I am thinking of writing an article about demo accounts – how to use it the correct way, what to look out for, what not to do and so forth. Be sure to check it out for more info

Happy Demo Trading 🙂

Moises Mease

LEVEL 1 : NEWBIE

REVIEWS 7 | REPLIES 2

#2084

number1options

September 16, 2015 at 7:23 pm

Thank you for coming back to me Alex. After I posted the question I thought it will be a little hard to answer and it is totally understandable. I will definitely check out your article like I always do.

Cheers

Gil Gorka

LEVEL 1 : NEWBIE

REVIEWS 6 | REPLIES 1

#2086

gil101gil

September 16, 2015 at 9:31 pm

I am amazed at how accurate the figure “14 stages of trader emotion” is. I can definitely relate to the feelings that you refer to. It was a little more paramount when I still used to trade the spot forex market compared to my binary options trading. I would keep on taking a loss just to see the market reverse and hit my target. I started getting so upset and searched for ways to overcome this and then I found binary options. I have never looked back since then. Binary trading is just so much easier and less stressful for me.

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