Trading psychology is just as important to an investor as their knowledge and ability to learn. If we strip away the various layers of the trading mindset, it can be summed up in one phrase, how you cope with the risk/reward ratio. Many people automatically assume traders are “risk takers” when this is not necessarily the case. Discipline is just as important as the ability to spot an opportunity and go for it.
What is Trading Psychology?
When we talk of trading psychology, there are numerous emotions/skills to consider, described as two sides of the same coin. For example, a trader has to be quick-witted but also needs to have thought through their next move. They need to exercise a degree of discipline and appreciate their gut feeling about a particular trading opportunity. So, for every emotion associated with trading psychology, there is also an exact opposite to consider.
Many people attribute the success of top athletes to innate talent. Much of that is well deserved, but training and discipline also play a major part. To climb to the upper echelons of any activity or field, you need to have that extra edge. Not all investors are born traders either. We will cover how to get to that stage in this article.
Why is Trading Psychology important?
Traders have to be decisive with the ability toact immediately. At the same time they also need to be able to stay calm at all times. They need to be “risk takers” but also exert a degree of caution. Surely these emotions and actions are counter-productive?
In a moment, we’ll examine two of the main emotions that dominate the minds of some trader’s psyche – fear and greed. One other emotion that is often overlooked when considering the attitudes and the actions of a trader is pride. This is summed up in the following quote:
“You need to know very well when to move away, or give up the loss, and not allow the anxiety to trick you into trying again.” – Warren Buffett
You also have to have patience as an investor, as a trader:
“The market is a device for transferring money from the impatient to the patient.” – Warren Buffet
In the early days, even gifted traders need to build a foundation for their future success. Over a relatively short period of time, a trader can experience emotions from both ends of the spectrum. How they rein in these emotions, control their thought patterns, and remain focused will dictate how successful they will be. However, once you stop learning, you are dead in the water.
Which emotions impact your trading the most?
There are many different emotions associated with good traders and elite traders. Two of the more commonly discussed emotions are fear and greed.
The relationship between fear and the risk/reward ratio
Unfortunately for many traders, fear is an emotion that can quickly dominate their mindset and dictate their actions. This emotion could see traders closing down a profitable position too early, thereby generating a substandard return. They tend to focus too much on the actual return instead of continuously adjusting the risk/reward ratio. At some point, this may indicate there is significant upside remaining for relatively little additional risk. While it is “never wrong to take a profit” there is also another saying in the stock market:
“Run your winners, cut your losers” – Anonymous
Those who are not disciplined, focused, and have not fully delved into investing, often do the exact opposite. They run their losing trades, with pride often to their detriment while cutting their winners, so they can at least “bank” some profit. It is easy to get drawn into this ultra-cautious, very damaging mindset, but it is hazardous for an investment trader.
The relationship between greed and the risk/reward ratio
Someone with sound trading psychology will appreciate the changing risk/reward ratio as futures contracts or other asset prices move in their favor. They will “leave something for the next person,” which may sound a little bizarre. This means that experienced traders would be happy to sell just before the top of the market before the trickle of sellers becomes a tidal wave.
“The trend is your friend until the end when it bends.” – Ed Seykota
Those who don’t fully appreciate the ever-changing risk/reward ratio will try to squeeze every last dollar out of their investment, even if the additional reward does not warrant the risk. Greed is a mighty strong emotion and the nemesis of many a trader. Remember, there is a direct correlation between risk and reward. If there was no risk, then there would be no reward. It really is that simple.
Common Mistakes Caused By The Wrong Mindset
You’re probably starting to think about how you can change your mindset and improve your own trading results, and be more flexible. We will now give you examples of common mistakes caused by a wrong mindset that trading psychology can help avoid.
Finding information to match your theory
Does this ring a bell? Sometimes, as traders, we will see what we want to see and ignore information that does not fit in with our beliefs (our pre-determined views). An experienced trader would see both sides of the argument, be able to weigh them against each other, and come to a sensible conclusion. Many traders have already made their minds up about their next investment before even considering the fundamentals.
Losses play heavy on your heart
While the prospect of a loss should never be taken lightly, it all needs to be judged in relative terms. If you took out an option and the market turned against you, but you sold on the first downturn, then in relative terms, you made the right decision. Yes, you may have taken a bath in the short-term, but this could have been a lot worse. It is important not to focus on losses, learn from them, but don’t let them dictate your future trades. The most common consequence is cutting your winners too early.
Mind over matter
History does repeat itself regularly, in all walks of life. This is more relevant to the markets than many others, but drawing the correct conclusions can be challenging for many traders. When faced with facts and figures regarding an investment, subconsciously, it is easy to recall “similar” experiences of years gone by. Whether a positive experience or a negative experience, very often, this can cloud your judgment – even though the facts and figures, in the form of the current risk/reward ratio, are staring you in the face. Things change. Nothing stays the same forever!
Following, like lambs to the slaughter
There are many examples where traders have had their fingers seriously burnt when following trends, akin to following lambs to the slaughter. One example is the recent volatility in the GameStop (GME) share price:
When the coronavirus pandemic had a huge impact on company sales, the share price was in the single digits with expectations of serious financial trouble. Hedge funds took out short positions, making their opinions known to the wider investment community. Akin to a self-fulfilling prophecy, the share price came under huge pressure in the early days. However, members of the website Reddit sensed there was an opportunity, and engaged in a so-called short squeeze.
To appreciate this situation, we need to put aside the fundamentals of the company for a moment. As thousands of investors began to buy GameStop shares, this caused a huge increase in the share price. The huge volume of short positions exacerbated the price squeeze, and the shares increased from less than $10 to an intraday high approaching over $300. However, what happens if the fundamental financial position of the company is as bad as first thought?
While those who shorted the stock before the phenomenal rise face multibillion-dollar losses, this “artificial” increase in the share price has created yet more opportunities to short the stock. The phenomenon of “private investor power” makes great headlines, but if the fundamentals are weak, the price will eventually return to the “correct value.” The subsequent fall to around $100 has been a sharp one. However, those who shorted the stock at approaching $500 a share are now making serious money.
There is nothing wrong with making money by following the trend, but within the context of a lamb, once you see the slaughterhouse, it is time to back out. As an investor, a trader, someone faced with the reality of the situation, you need to react quickly.
Don’t get emotionally caught up in investments
Many of us can still remember the first big trade we made, the purchase of a futures contract before the market went through the roof. Whether we like it or not, we are all human in our way of thinking. While there is a time and a place to get sentimental, it is not when you decide your next trading position!
Many successful traders see futures contracts, stocks and shares, and other assets as “empty boxes.” If there is nothing in these boxes, there is nothing to get sentimental about and nothing to bend your natural trading instinct. This does not mean that you should not learn from every investment, both successful and unsuccessful. However, don’t automatically assume that history will repeat itself. That moment you invest blindly, believing that something is inevitable, is often the time when the trend changes forever.
How Can Trading Psychology Help You Avoid These Mistakes?
In summary, there are many ways that trading psychology can help you avoid the above errors of judgment and stop your mind from being clouded:
Look at the pros and cons of every investment
Look at the pros and cons of each investment, potential reasons to buy, and potential reasons to sell. That way, you can take a balanced approach, not one biased by your way of thinking. It is important not to go looking for facts and figures that support your preconceived beliefs. This is very dangerous!
Don’t let losses dictate your future decisions
Cut your losses and run your winners. While easier said than done, we will go further with this particular comment. Do not let losses of the past, often uncomfortable experiences, allow you to lose sight of your risk/reward ratio. Successful traders won’t forget their losses, but they won’t let them cloud their judgment going forward. Think of it as a clean slate after every trade.
The brain is a powerful organ
Mind over matter, history repeating itself; these are common thoughts swirling around our minds. A successful trader will create a balanced opinion on a particular position, taking on the pros and cons in front of them today. An unsuccessful trader will ignore the facts and figures in front of them. They will revert back to anecdotal experiences of years gone by and give these thoughts more prevalence. Just think, memories you have of incidents weeks, months, or years ago often become blurred. Indeed, on occasion, it is easy to rewrite history in your own mind, again, very dangerous as a trader.
The trend is your friend, until it changes
It’s true what they say; the trend is your friend when it comes to investment markets. However, akin to the clever lamb turning about-face, moving in the opposite direction, at first sight of the slaughterhouse, don’t get sucked in. The power of momentum can create huge short-term volatility in market indices, futures contracts, and any other investment type.
However, once the supply/demand ratio balances out, things can look very different. Many people assume that the hardest decision is when to buy futures contracts. In many ways, the most difficult decision is when to sell them and close down your position.
11 Trading Psychology Tips to Get You Back On The Right Mindset
We will now look at several tips to get you back in the right mindset and start banking trading profits. While many of these tips may seem “obvious,” be honest, do you follow them?
1. Never stop learning
Whether you are just entering the investment trading arena or have decades of experience, never stop learning. The moment that you think you “know it all” is the time when the market will bite you on the backside and leave you destitute. After all, even Warren Buffett never stops learning. He readily admits he does not understand the new technology wave, but his colleagues do.
2. Believe in yourself
If you don’t believe in your own research, your own gut feeling, and your own ideas, why are you even investing? Why not simply give your money to a 3rd party investment company, let them charge a management fee, and leave it with them? If you just “follow the trend,” when do you know the right time to get in and the right time to get out, if you don’t trust your own call?
3. Mistakes happen
If you turn to investment trading with the idea that you will never make a mistake, you live in a dream world. If you don’t manage to rack up any losses, then either you are infrequently trading or working on a rock bottom risk/reward ratio. Psychologically, there is evidence to suggest that losses hit you harder than profits. Trading psychology won’t help you completely avoid mistakes, so learning from them is priceless further down the line.
4. Move with the times
There is a reason why the dinosaurs became extinct. The same will happen to you unless you learn to move with the times. The futures market is proving particularly popular with day traders and those looking to bank short-term profits. There is nothing wrong with backing your own research, your own ideas, and if the trend lines and graphs patterns back this up, then even better. Use whatever tools are available to you.
5. Visualize your trading
There is no better feeling than banking a profit, although avoiding large losses is a close second! So, whether going long on futures or short on futures, visualize your trading, how you imagine your position evolving, and the level of profit you would be happy with. When you visualize your trade going to plan, remember that feeling of joy when you bank that “profit.” Focus on that, feel it, and make that your target.
6. Don’t discount alternative opinions
While this may have the same look and feel as “never stop learning,” it is very different. You might look to go long on a futures position while others may see a short position emerging. Don’t discount their alternative opinions. Read them, listen to them, take them in and then present your own arguments on paper or in your mind. If you still truly believe your argument, go for it!
7. Run your winners, cut your losers
Whether looking at stocks and shares, futures contracts, or any other type of investment, running your winners and cutting your losers is excellent advice. Bizarrely, many people do the exact opposite because they panic and sell too early while letting their losses grow out of control. If you are successful in running your winners and cutting your losers, you should have an outstanding career as a trader!
8. Never gamble everything on a “dead cert”
If there is a significant return to be had, then by definition, there is a significant risk – this is the basics of investment. Many traders feel the temptation to gamble everything on something you think is dead certain, especially when trying to recover from recent losses. There is no such thing as a “dead cert.” An important part of trading psychology is to refrain from increasing your risk profile in challenging times. You are not playing poker!
9. Be flexible, nothing is set in stone
As we touched on above, there is a certain degree of satisfaction when visualizing a futures trade that goes perfectly to plan. However, things change, other opportunities emerge, and therefore it is important to be flexible. We aren’t suggesting jumping between different futures contracts for the sake of it, but nothing should be set in stone. Remain open-minded at all times!
10. Only take calculated risks
There is a common misconception that high risk is a central part of trading psychology. While some trades may look risky, you need to take into account both sides of the calculation. If there is a significant risk, then a trader has decided there may be an even greater upside. If the risk is greater than the potential rewards, it doesn’t make sense. You will never “back the winner” every time, but you can reduce the number of duds by monitoring and understanding the risk/reward formula.
11. Control your emotions
Last but not least, all successful traders will control their emotions while being flexible and realistic. They may use stop-loss limits to reduce the downside, but they will never be panicked out of a position without thinking it through. As they say, “act in haste, repent at leisure” – something that many traders need to remember.
If it helps remove further emotion, think of each investment as an empty box. There is nothing inside the box, so you won’t have an opinion, and you can’t relate this back to historical investments. There is a difference between using your emotions as an investment tool and controlling your emotions.
A Comparison Between Winners and Losers in Trading
There are numerous behaviors with separate winners from losers and the dreamers from the realists. Two main elements come out of this article, the need to control emotions and appreciate different opinions and counterarguments.
|NO EMOTIONAL CONNECTION WITH AN INVESTMENT||Making investment too personal and emotional|
|VISUALISING THE ENDGAME FOR EACH TRADE||Failing to recognise entry/exit strategies|
|TAKING THE OPINIONS OF OTHERS INTO ACCOUNT||Blindly believing they know everything|
|THE COURAGE TO CUT THEIR LOSSES||Failure to accept they may have “gotten it wrong”|
|BLOCKING THE EMOTION OF PANIC FROM THEIR MIND||Acting in haste, repenting at leisure|
|ENTERTAINING DIVERSIFICATION AND OPTIONS||Going all-in on something “dead certain”|
|THE COURAGE OF THEIR OWN CONVICTIONS||Overly influenced by third parties|
|STICKING TO WHAT THEY KNOW||Blindly following the trend|
|MAXIMISE PROFITS WITHOUT BEING GREEDY||Continually chasing that last dollar of profit|
|TAKING A REALISTIC APPROACH TO INVESTMENT RETURNS||Expectations of unrealistic returns|
In reality, the behaviors on the left are the exact opposite of the behaviors on the right. So, in the early days, you will probably notice a number of your behaviors on each side of the table. If you can bring those arguments in the loser’s column to the winner’s column, this will have a huge impact on your long-term investment returns.
Final Thoughts on Trading Psychology
Just as some people are talented at leading large conglomerates or represent their country at the Olympics, many people have an affinity for trading psychology. They may not know this in the early days, they may need an element of training, but some people have an invaluable skill at spotting risk/reward ratio imbalances.
These traders may come across as arrogant and unwilling to listen to other people’s views at first sight. In reality, they are constantly seeking and alternative opinions to challenge their own investment ideas. The nuts and bolts of trading psychology revolve around emotions and the ability to entertain alternative thoughts. However, all successful traders will also have a high degree of self-confidence.
After all, if you don’t believe your investment ideas, why are you even contemplating being a trader?