Trading Psychology: Why It’s Important

Thu Feb 11, 2021, 11:18 am | by Alexis Jurcak | No comments

You may be wondering, how does psychology impact my trading success? Well, psychology actually has a lot to do with how you make trading decisions and formulate a trading plan. As a trader, you’re expected to make quick decisions. Sometimes emotions get in the way of making these quick decisions and can cost you big money. 

In this blog post, we’ll review what is trading psychology and the factors that contribute to it. We will also learn common biases traders fall victim to and how to overcome these biases so you can consistently be a strong and successful trader. 

What is Trading Psychology?

Whether you’re conscious of it or not, there are external and internal factors that influence your behavior and characteristics which ultimately affect your trading success. Trading psychology plays an important role in the foundations of a successful trading strategy such as how disciplined you are and the risks you’re taking. Understanding that certain emotions like fear, greed, and anger can only set you up for failure in the long-run sooner rather than later can yield more positive results in your trading journey. 

The ability to relax aggressive emotions to allow your mind to think clearly and quickly all while demonstrating a disciplined trading strategy can be summarized to describe what trading psychology is. 

How Understanding Your Trading Psychology 

It is common to hear expert traders telling beginner traders to “stick to their trading plan,” or that discipline is the number one way to be a successful trader. What many people don’t realize is that trading psychology is the foundation for mastering these key tools for success. In order to stick to a disciplined trading plan you must not let your emotions get in the way. Letting your emotions cloud your conscious thought can affect how you make quick decisions, a necessary skill for traders. Two of the biggest emotions that ultimately affect the success of a trading decision are fear and greed. 

  • Fear: It’s quite common for traders to get scared or discouraged when they hear bad news. The announcement of bad news can lead one to making hasty decisions as a result of fearing the loss of money. Allowing fear to control your trading decisions can make you hold on to losers, refraining you from taking risks. 

One way to overcome this emotion is to do research and form your trading thesis. Having a solid understanding of the trades you’re making and why you’re making them will solidify your trading confidence. Eliminating fear also comes from an understanding of the way you perceive certain events is not always what the truth is. Allow yourself to be reminded of the research you’ve put in and realize that you can move past this emotional response to make smart trading decisions. 

  • Greed: Throughout your trading journey you are inevitably going to experience “FOMO,” or fear of missing out, from other trader’s successes. Seeing others’ success can fill your thoughts with just being a little better, or “If I just made a little more money I would be better.” Falling victim to this emotion will only hinder your trading success in the future. It’s important to remember that everyone has their own trading journey and their own trading styles. What works best for one trader may not work best for you. Developing greedy trading habits will throw you off from your trading strategy leading you to make unrationalized and hasty trading decisions. 

Main Contributors to A Trader’s Psychology 

Remembering how certain characteristics can affect your trading decisions will allow you to take a deep breath and continue to make well-thought out and rationalized trading decisions. Laura Wagg, author of “Understanding the Importance of Trading Psychology” on nadex.com describes the following factors as main contributors to one’s trading psychology. 

  • Personality and Characteristics: Each trader has their own unique traits that affect the way they make and execute decisions. Realizing how you react to certain situations can help you formulate your trading strategy
  • Emotional Responses: These are chemical reactions that occur in the brain that we sometimes don’t have full control over. The lesson here is to learn to recognize those emotions that cause you to make impulsive decisions and correct them in a way that allows you to stick to your trading plan 
  • Behavioral Biases: Melissa Lin, advisor for Fortune 500 companies across multiple sectors,” mentions a few of the common biases traders face. 

Overconfidence: Studies have shown that many individuals believe they have more control over their investments than they actually do. A study conducted in 1998 reported that expert investors who relied on their own stock picks for their portfolio performance overlooked broad influences that negatively impacted their portfolio. 

Self-Attribution: Traders who suffer from this bias also suffer from overconfidence. When self-attribution bias occurs traders reward their success to their own doing while blaming their failures to outside factors, at no fault of their own. As a result, traders who don’t learn to recognize and correct this bias will never learn from their mistakes to improve their trading strategy and ultimately be unable to grow in their trading career. 

  • Social Pressure: This is another reflection of suffering from the emotion of greed, or “FOMO,” also commonly referred to as “herd mentality.” Traders who experience this emotional response will react in an irrational way to keep up with the winnings of other traders who they think are outperforming them. 

Reaction to Losses: How to Correct Them

As a trader, it’s inevitable you’ll encounter losses and even losses so big that you feel as if you can’t recover from them. In order to be a successful trader long-term, it’s important to learn how to control your emotions when this situation happens so you don’t jeopardize your whole trading plan. 

Remember that emotional trading is just as detrimental to your trading success as a big loss. In order to recoup from a big loss, you should take the time to reflect on how that loss can be a teaching moment. See where you went wrong, accept that you were wrong, and use that to improve your trading plan so you can come out of that as a stronger, more confident trader. 

Tips to Handle a Big Loss Using Trading Psychology 

Here are a few practical ways you can use trading psychology as a foundation for handling losses as mentioned by The Secret Mindset

  • 1. Control Your Losses: Make a record of your average winnings and let that be an indicator of how much risk you should take. Sticking to this allows you to express strong risk management and keep losses at bay in the long-run. 
  • 2. Know the Stop/Loss Level before Entering a Trade: This strategy is something that a lot of traders overlook. However, your stop/loss level should be considered an insurance policy. Know beforehand the amount you risk losing by following a 1% risk per trade rule. 

Discipline and keeping emotions as bay play a huge part in this. It’s advised to not widen your stop-loss level when the market moves negatively. Remember, there is always a better trade around the corner. 

  • 3. Admit When You’ve Messed Up: When you blame your failures on external factors, you’re only hindering your trading success. Allowing yourself to admit when you’ve messed up can let you see where your trade went wrong. This can help you tweak your trading plan to set you up for success in the future. Learn from your mistakes!
  • 4. Trade at Lower Position: Coming back from a big loss can be hard and can cause you to lose confidence in your trading abilities. Take time to clear your head and start trading again in a demo account. Trading in a demo or paper trading account can help you get in a few wins to encourage you to gain confidence again. Once you actually begin trading, still start off with smaller positions. Seeing small winnings can help you bounce back emotionally, reiterating calming your emotions to let you make rational trades. 
  • 5. Embrace the Process: Trading is a journey of learning. Educating yourself on where and why things went wrong and researching how you can improve your strategy will yield positive results in the long run. Keep in mind that aggressively thinking about making money versus focusing on improving your strategy can set you back. Open up room for improvement and welcome it as a trading advantage. 

Final Thoughts

Trading psychology is an important tool to keep under your belt. Remember that allowing your emotions to control how you make and execute decisions is not part of a solid trading plan. What makes a solid and strong trading plan is one that is improved through embracing failures and flaws. Sticking to your trading plan will require a lot of discipline, but that process can easily be mastered by recognizing what emotions distract you from making sound trading decisions.