Trading Psychology 

9.1 Understanding Trading Psychology

Trading fundamentally involves the art of making well-timed decisions. These decisions often hinge on a trader’s comprehension of the market, drawing from information derived through technical and fundamental analysis. However, a predominant influence on these trading decisions is the trader’s psychology – their mental and emotional state during trading, which is shaped by their beliefs, personality, and past experiences.

Every trader possesses a unique and multi-faceted trading psychology, which they must explore and master.

This endeavour is worthwhile because traders who effectively manage their trading psychology are less likely to make emotionally-driven decisions that can lead to costly mistakes.

Let’s begin by examining how two primary emotions, greed and fear, impact trading psychology.

9.2 How greed and fear affect trades

First and foremost, it is crucial to recognise that greed and fear are natural human emotions, and experiencing them is normal. In some instances, seasoned investors even use these emotions as subtle signals to enhance their trading instincts.

Problems arise when fear and greed cloud judgment, leading to a lack of discipline and irrational decision-making that can jeopardise trading outcomes.

When traders receive unfavorable news that could affect their positions, fear naturally arises as a response to the perceived threat to their profit potential. In response to fear, traders may attempt to protect their profits by closing positions prematurely or avoiding potentially profitable trades. Paradoxically, acting out of fear can harm profit potential.

Conversely, greed can lead traders to remain in a trade long after it’s beneficial. This often happens when a trade experiences unexpected, aggressive movements. A greedy trader may be tempted to keep the position open, only to witness the trade abruptly reversing and erasing their returns. If the trader decides to adhere to the take-profit point and closed the position as planned, they could have locked in profits. Instead, giving in to greed often leads to reduced returns.

9.3 How to manage trading psychology

The challenge with greed and fear is that they can prompt traders to act irrationally while believing their actions are logical. Here are three strategies to manage emotions and reduce their impact on trading:

Be consistent with your trading plan

In Module 7, we discussed the importance of creating a trading plan. Recall that a trading plan spells out your goals, objectives, strategies and risk tolerance levels. 

In managing trading psychology, it helps to refer back to your trading plan often and remind yourself to stick to your pre-defined limits.

For instance, adhering to your stop-loss and take-profit points can stop you from going too far and losing your returns. 

Meanwhile, maintaining proper trade sizing can give you the confidence to proceed with your trade, or prevent you from risking too large a position. 

Conduct research and improve your knowledge

Traders should continuously expand their knowledge of relevant markets. For stock traders, this means keeping up with global economic and political news – something you’re already doing as part of fundamental analysis (see Module 5). 

Conducting research and improving your knowledge can help you critically evaluate news or developments instead of being swept along when the markets turn greedy or fearful. This can help you avoid giving in to your own emotions and inadvertently making a mistake. 

In the age of AI, it is ever more important to distinguish between genuine and fake news. In May 2023, a fake photo of the Pentagon under attack briefly caused a market drop, even though the photo was later revealed to be generated by AI ^[1].

While the sell-off was likely initiated by trading bots programmed to react to such events, this event nevertheless highlights the potential for A.I. to cause havoc in the markets. Hence, it’s a good idea to cultivate a list of trustworthy news reporting, analysts, and education sites for your own edification. 

Remain flexible and keep honing your skills 

A third tip for managing trading psychology is to recognise that trading is a lifelong learning experience, given that the market is dynamic and constantly changing.

As traders grow in experience and skill, they will naturally form their own theories and strategies. However, it is important to maintain a flexible mindset and update your knowledge when confronted with new evidence and experiences.

Staying flexible also means being willing to admit when you’re wrong – the sooner you accept that your thesis about the current market is invalid, the quicker you can change direction and move with the market, rather than against it. This can prevent you from taking losses simply because you were too stubborn to acknowledge when all the signs were indicating a different course of action.

Remember that while we may have our favourite trades and strategies, that doesn’t mean they are the right plays to make all the time. When market conditions demand a different approach of trading, it is up to us as traders to adapt and keep up. 

This means being able and willing to constantly expand our trading toolkits and refine our skills. 

Check out a more in-depth article on trading psychology.

Module recap

• The largest influence behind our trading decisions is our trading psychology. This influence can sometimes be very subtle, which can make it difficult to spot.
• Trading psychology may be thought of as our mental and emotional state while trading. Personality, beliefs, and past experience may also play a part.
• Traders who master their trading psychology are less prone to emotionally driven decisions, and thus have a higher potential to succeed.
• For most traders, the main driving forces between trading psychology is greed and fear, and the interplay between these two emotions.
• Feeling fearful or greedy is natural, but problems can arise when we give in to their influence and make irrational trading decisions.
• Fear can cause us to close positions too early, or even stop us from entering potentially profitable trades, reducing our overall returns.
• Greed can cause us to lose profits by keeping positions open for far too long, or risk losses on positions that are improperly sized.
• The three ways traders can manage trading psychology are sticking to their trading plan; conducting research and gathering knowledge; and staying flexible and constantly honing their skills

Reference

1. “Fake image of Pentagon explosion goes viral, briefly sends jitters through stock market – Channel News Asia” https://www.channelnewsasia.com/world/fake-image-pentagon-explosion-united-states-ai-generated-viral-stock-market-3507806 Accessed 28 Dec 2023