The Importance Of Trading Psychology

Last Updated August 16th 2021

8 Min Read

Trading can be a profession that calls for high levels of technical understanding of the market and stocks. Traders also get better and better with time and experience does carry weight. But what often gets underestimated but plays a crucial role in the success of a trader and his performance is his psychological wellbeing - this is often referred to as trading psychology.

What Is Trading Psychology?

Trading psychology refers to the mental state or the mindset that a trader is in while performing his job of buying and selling securities. All the emotions and feelings he undergoes have a profound effect on his behaviour during trading and on the outcome of his trades.

How Is It Important To Trading?

So is trading psychology such a big thing is what most people wonder. Surely, the successful trader just needs to be a wizard at reading into which stock is likely to gain and fall and how he can use that to his advantage, or the long years of experience he has in the profession.

But even the most talented and the most seasoned of traders are humans, after all, and have to face difficult situations that demand coping with surging emotions and inherent biases. These can suddenly ruffle even the calmest of professionals and have an impact on their functioning. In a profession like trading, that can mean taking a wrong decision under pressure or a hasty one in a hurry. The ramifications of that can be a loss that, in turn, can disturb him further.

The only way that you, as a trader, can cope up with your emotions and the mental challenges is to understand the importance of psychology and how it can influence your trading. Therefore, it helps to know what exactly contributes to trading psychology.

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What Contributes To Trading Psychology?

There are a variety of factors that contribute to the complex world of trading psychology. Each of the factors plays a big part in influencing the moods and behaviour of a trader at work.

Personality traits

The individual traits of the personality of a trader and the characteristics he possesses can be a major contributor that determines his psychological framework.

There are some who are impulsive while others may be indecisive. While there might be those who are bold, others still, may be over cautious. Whatever these are, they are bound to have an influence on the trading performance. These may be traits intrinsic to them and part of their personality but they would have an impact on the outcomes at work. A trader needs to identify the traits that are beneficial for his work and improve them. Likewise, he should recognise the ones that are harmful and consciously eradicate or contain them.

Emotions and responses

As humans, we are all vulnerable to emotions and these can affect us both in our personal and professional lives. For a trader, being exposed to such emotions at work is normal but also can have an impact on your actions. When these go unchecked and become overpowering, this can have adverse results too.

Here is a walk through of just a representation of the most commonly endured emotions and understand how they affect you as a trader.

Fear: Even the best and veteran traders encounter fear once in a while and this emotion has the ability to cause enough distraction to make wrong decisions. Second-guessing a purchase or making a panic sale or even worrying about huge losses are natural fallouts. Basing your decision on technical analysis and using risk mitigants like a stop loss can help here.

Greed: Trading, as a profession, is all about making money and greed is one emotion that comes naturally to the market. To resist the temptation of trading after hearing a rumour or going with the herd in a bull wave are examples of how it can spell trouble. It is best to do your research well and have risk measures in place.

Regret: Traders make mistakes and the bigger mistake here is to dwell on them. Feeling regretful is okay for the learning the failure provides. But to allow it to disturb you and impact future trades can be detrimental.

Pride: It is natural again to feel pride over a successful trade. But it is important to not rest on that success but to move on to the next trade. Remember, it is a marathon you are running and there could be challenges ahead.

Happiness: Again, in a difficult profession like trading, feeling happy and contented is as much a reward as the money you make. Just be in control of this emotion too and enjoy the moment and stay calm to handle the next trade.

Biases

Another key factor that affects the psychology of traders is the prevalence of biases. These are the preconceived notions that individuals carry that influence their acceptance and rejection of things.

Having a bias commits you to a reaction even in trading where you approach a situation with a set frame of mind. These can impact your decisions to buy or sell or take a position or leave it. The real danger here is that, as a trader, you would go with your biases more than with data and technical or fundamental analysis.

Biases can be classified into five broad categories and each has a potential impact on trading psychology.

Confirmation bias: This is information that confirms your point of view or opinion and your tendency to seek out only conclusions that confirm it. In such cases, you would not be open to anything that does not suit your standpoint.

Representative bias: Here, you accept anything that follows an earlier situation where you have encountered success. The risk is here is in approving something that has the approximate same background without additional analysis or study.

Negativity bias: In this case, you tend to get swayed by the negative side of a situation enough to consider it an overall failure. Without seeing the positive side and assessing the chances for it to succeed, you write it off without further study.

Status quo bias: The status quo is what you will go with here and will not consider new methods or approaches to the same problem. As a result, you lose out on solving a new problem by relying only on old solutions.

Gambler’s fallacy: This is the classic mindset of a gambler who gets sucked into a winning situation and refuses to see the risk inherent in it. Just because a stock continues to rise, he feels there is more upside and fails to look at things objectively.

External pressures

When a trader looks around and sees others moving in one direction, he falls prey to the herd mentality and gets swayed to follow the majority. The dreaded FOMO or the Fear Of Missing Out syndrome can influence him enough to stop thinking rationally and analytically.

How To Improve Trading Psychology?

1. Assess yourself

Before you even begin your stint as a trader, size yourself up both on your knowledge and skill abilities as well as your orientation and aptitude. Once you have understood all the challenges and requirements of the job, are you still sure this is your calling? Would you want to be trading all day long and for years together and still look forward to another day at the market?

If you think you can handle all that trading throws at you and can keep calm and learn and enjoy your successes and absorb your failures, you are ready to be a trader.

2. Plan your trading

You must have a clear plan as to how to start your trading career. You should define your goals and set out your strategies. Keep a log to track wins and losses and have a clear overview of your finances.

3. Start modestly

Trading is a difficult profession that demands high levels of knowledge and skill. It is also a high-pressure job where even experienced professionals can stumble occasionally. If you are a beginner or have little experience, it is best to start modestly. It is ideal to use demo accounts, paper trading or even simulators before trying it in the real world. This will ensure you get enough practice that helps handle the actual action.

4. Learn continuously

In any job, knowledge is a great tool that can help handle complex situations. In trading, it is equally important and there is no alternative to learning and constantly updating yourself with everything on markets, the stocks you are trading in and the trading process itself. The chances of making mistakes reduce greatly when you know what you are doing and dealing in. Make it a point to continuously learn as you grow.

5. Focus on risk management

Trading comes with enough instances for mistakes to happen and these can be both forced and unforced. Every trade has an inherent risk attached to it and the greater the risk the more the chances for a monetary loss and, therefore, the reason for a trader to get affected psychologically. To avoid this, it is best to have a strong risk management orientation and adhere to it. Employing the 1% risk per trade thumb rule, diligently using stop loss measures and studying technical and fundamental information can help in this regard.

6. Don’t dwell on a failure

Often, failing can demotivate the best among men and make them doubt themselves. What is important is to introspect and understand what went wrong. In trading too, there are many variables and dependencies that can stand between success and failure. Assess if it was just a careless error or a combination of external factors that caused a trade to falter. Learning from your own mistakes and also recognising the factors that came in your way is more important than just taking the failure personally and dwelling over it.

7. Absorb success elegantly

It is easy to get carried away by success and to forget that every trade may not go your way. Remembering that success is not a given and that it is actually the result of hard work and effort is important. That helps you take it more gracefully and work harder to earn it.