A lot of people say that psychology is one of the most important elements of trading. Well, is it? Of course it is important. In this unit I will go over 3 main elements that impact trading psychology:
- Understanding what trading is.
- Identifying where you are in the process.
- The different types of psychological pressures and cognitive biases that can affect you and your trading.
Understand that it’s a process
Like anything you do in life that is difficult to achieve your state of mind will have a big impact on your performance.
However, what many people forget when talking about trading psychology is that the first and most important step is this – you have to understand what trading is.
Trading is a skill that takes a time to fully master. You start by educating yourself on the basics and it takes years to learn the knowledge and gain the experience you need to be successful. It is a process.
Do any of you out there believe you can become a pro sports person and compete in the Olympics just by mastering your psychology? Of course not, you can meditate 20 hours a day and achieve yogi master state but you are not going to win a gold medal without work.
So in fact the first psychological barrier you need to cross is the one where you admit to yourself that this will be something you will need to work hard at. You will have to educate yourself, commit to hundreds of hours of practice – going through thousands of charts and putting theory into practice by demo trading and finally building your own backtested strategy.
This does not only apply to technical traders but also fundamental traders as you will still have to analyse economic data and build a strategy around that.
This will be the best psychological help you can give yourself to build your psychological confidence.
Evaluate where you are in the process
Before going into the details of the different psychological elements that can affect your trading you need to think about where you are in your own trading journey.
There is more to this than just trading psychology, first and foremost is human psychology – are you ready to start this journey? Do you really want financial independence or is it just a nice daydream? Do you realise that it takes sacrifice to build a trading account such as saving money and not watching Netflix when you should be practicing. Are you prepared to take the risks involved in trading and are you prepared to fail?
If your commitment to this is less than it would be when building any new career then don’t waste your time.
If you are committed to all this then great your next big step is to honestly evaluate where you are in the process. There is no point working on performing under pressure when you can’t identify a basic trend or key support and resistance levels.
And if you have educated yourself in the basics and you are telling yourself that you need to work on your psychology because you exited a trade too early but you had no strategy – clear entry parameters, stop losses and target levels then you don’t need to work on your psychology, you need to work on your strategy!
Trying to skip ahead can be one of the most difficult steps in this process but there is no secret trading psychology to fix this. This is simply having a clear vision of what you want to achieve in your life and being focused and disciplined in working through the steps to get there.
Understanding cognitive biases
Ok – now that you are committed to the process and you are not going to fool yourself into thinking you can skip the steps to becoming a successful trader we can look at some of the psychological biases that can impact any individual.
Herd mentality or mob mentality is when people follow the crowd rather than their own analysis. In relation to trading this can mean taking a trade that makes no sense just because everyone else is doing the same thing.
This is an interesting bias because this is closely related to market sentiment. Some strategies may actually focus on following the crowd! The important thing about this bias is to recognise that it exists. You may follow the crowd to take advantage of a trend but don’t fool yourself into believing that the crowd is right.
Here is a great example of herd mentality with the Bitcoin bubble of 2017/18.
Fear of missing out or FOMO is related to herd mentality and is a dangerous psychological bias because it can cause people to act irrationally. People fear missing out on a potential profit, especially when they see fast moving markets and other people making money.
FOMO can happen more often in fast rising markets or bubbles. What people forget is that the increase in volatility that leads to big profits is the same volatility that can lead to big losses.
Markets can be driven by emotion so a sense of FOMO will be reinforced as herd mentality takes over and pushes the market further in that direction. Again let’s look at this on the Bitcoin bubble chart.
“Recency bias” is when traders give more importance to what has happened in the recent past (recent trade performance, news or information) and ignore their previous performance or market trends.
This can happen very often in strongly trending markets (especially bull markets) which leads to people saying things like: “Markets only go up”. But the reality is that markets can go down just as quickly as they go up.
Anchoring is one of the worlds most widely used cognitive biases. It is most often used in negotiations or price comparisons, setting a “low anchor” is when someone offers a really low price for something. It is also used when shops discount from a higher price.
In trading, anchoring happens when a trader picks a price in a range and anchors themselves to the position. For example if a market drops sharply, the trader may anchor themselves to the recent highs believing that the lower price is “cheap” but the reality is that it can fall even further.
In both these examples, the real value of the asset could be something completely different. In trading this anchoring can be compounded by the recency bias if a trader doesn’t compare that anchor to past performance.
Who enjoys losing money? No-one of course and actually people really hate losing money. In psychology the term loss aversion refers to people’s desire not to lose money. In fact, people will actually act more strongly to avoid a loss than to secure the same gain.
In trading, Loss aversion makes traders unwilling to take a loss. When this happens, people abandon their trading plans and run loses far longer than they should due to the psychological bias and hope that the trade could end up profitable. This can often lead to greater losses!
If people really want something to be true then they will find a way of justifying it. What this means for traders is that instead of evaluating a trading idea based on all the evidence, they will only look for evidence that suggests the outcome they are looking for and ignore any evidence that says the opposite.
Confirmation bias is very easy to do as our brains are lazy by nature and are very good at filtering information. If you tell your brain you don’t want to hear bad news then it will be very happy to sit back!
Have you ever bought something you didn’t need or couldn’t afford because you ‘deserved it’. Ever eat an extra piece of cake because you will exercise “tomorrow”?
People can rationalise anything, why would you think trading is any different? The most common rationalisation traders make is that they can trade without a plan, that they will get out at the right time or stop their losses if it is not going right.
If you have ever eaten that extra piece of cake then don’t fool yourself, why take this risk with trading where the consequences are much more severe.
The best traders avoid rationalisation by simply following their system, over and over and over again.
Illusion of Control / Overconfidence
Illusion of control is when you have a false sense of control over an event that cannot control, while overconfidence is having too much belief in your ability and skills.
This can be very dangerous for all traders no matter what their level but especially for retail traders. If you think you have any control over the trillions of dollars being traded everyday then you must also believe you can move the ocean with a fork!
The only thing you can control is your trading plan, you will know when you have lost control when you start trading outside of your plan or overtrading. Build confidence in your ability to follow a plan, not to control the markets.
I hope you enjoyed this unit and it has made you think about your reasons for trading and helps you to be honest with yourself!