The edge that separates wealthy investors from failed ones is their mental approach to the markets. Trading psychology is extremely important, and the reason is fairly simple: A trader entering and exiting positions must make quick decisions. They need a certain presence of mind, so they stick with previously established plans and know when to book profits and losses. Stress and emotions can’t get in the way.
It’s important for a trader to be able to read a chart and have the right technology so that their trades get executed, but there is also a psychological component to trading that shouldn’t be overlooked. Setting trading rules, building a trading plan, having a risk management approach and getting experience are all simple steps that can help a trader overcome these mind matters.
When a trader’s screen is pulsating red (losses are happening), it’s not uncommon for the trader to get excited or scared. When this happens, they may overreact and liquidate their holdings and go to cash or worst, justify the position and continue to hold until tomorrow because it will be different this time. Now, if they do the latter they may find that they hold onto their losers longer than their winners. In the brokerage business this is called a churn and burn, you make good trades and make money and then give it all back, because you can’t stand to take a loss.
Losing is part of trading. Cutting losses quickly is an essential part of trading. Failure to exit or holding and hoping is the worst enemy of a trader. Having a plan helps but ignoring your plan is usually the big issue. Traders must peel back the onion and discover why they have the responses they do.
Traders need to understand what fear is – namely, a natural reaction to what they perceive as a threat. Have you pondered what the fear is about? History? Past loses? Baggage from years past can make for bad habits today, this is true even for the most experienced trader.
There’s an old saying on Wall Street that “pigs get slaughtered.” Investor greed causes them to hang on to winning positions too long, trying to get every last tick. This trait can be devastating to returns because the trader is always running the risk of getting whipsawed or blown out of a position.
Greed is not easy to overcome. That’s because within many of us there seems to be an instinct to always try to do better, to try to get just a little more. A trader should recognize this instinct if it is present, and develop trade plans based upon rational business decisions, not on what amounts to an emotional whim or potentially harmful instinct.
What most traders don’t realize until it is too late is how quickly one can lose a lot of money in a single trade often with disastrous consequences. More often than not this painful experience comes from poor risk management following a period of successful trading. It is natural of course. We are pattern seeking creatures and when something starts working for us we get confident in our abilities and quickly forget that we know very little about what the market or a given stock may do at any given moment. In short: We become overconfident.
It is after a period of successful trading that traders tend to loosen up on rules of discipline. They start thinking in term of dollar signs as opposed to the trade discipline. In short they think they can fly. Look how much money I would have made if I had traded x % of my portfolio. Stop yourself right there. While it is tempting to play mind games like this no good will come of it. Why? Because you just stepped overtly into the realm of one of the greatest sins of trading.
One thing humans are particularly good at is rationalizing. We can rationalize anything, especially our mistakes, because mistakes go straight to ego and ego is the last to go. We want to believe that we are in control when, in fact, nothing could be further from the truth. The illusion of control provides comfort. We feel more comfortable when we think we are in control, and of course feel very uncomfortable when we feel we have no control. Denial is an easy way to avoid confronting the reality that this trade just went bad because something happened that we didn’t foresee. The method we had so much confidence in suddenly stopped working. Or did it? Maybe it was just a fluke? So traders often dismiss the losing trade even though it hurt. The typical response: I’ll make it up in the next trade a cardinal sin of trading.
The second you start initiating trades to make up for a previous losing trade you may as well burn your money. Every trade needs to stand on its own set-up and rationale and cannot be emotional, linked to a previous trade. When you are trading emotionally feelings of anxiety, pressure and stress will creep in, none of which have anything to do with finding a good trade set-up. When another losing trade or set of losing trades starts to chip away at your confidence this exacerbates the situation, especially for a brain that is still fresh on the hunt for another dopamine high. You see where this spiral is heading.
It is about in this point in time where things slowly start going array for many traders. This may happen quickly, or it may take time, but unless addressed traders will start circling the drain that is their account. Frustration builds, discipline gets abandoned, anger, fear, panic, even paranoia can set in. Traders start taking things personally and are imaging what could happen as opposed to what is happening, signs of mental exhaustion are building. In short: What worked before isn’t working any longer. This spiral can literally ruin people.
FREE YOUR MIND
A poor trading method with poor technical analysis and preparation means you have no real edge this will quickly undermine your trading psychology. Similarly, a toxic mindset will render even the very best trading analysis and techniques ineffective. Trading requires both the post/pre market technical preparation and trade planning to develop an edge, but it also requires a set of trading skills to manage money and respond to what the markets give you.
Moderate levels of stress are stimulating, which makes trading less of a job and more of an adventure. If you exceed your stress threshold, however, you will get into an overload state which triggers primal emotions and defensive/aggressive behaviors.
In this stressed-out state of mind, you will become re-active rather than proactive. Your trading plan will be impaired. You will miss the obvious and lose impulse control.
Maintain a confident mindset
Aspiring traders pay far too much attention to what just happened in the market and not enough attention to their own trading psychology.
Successful traders actively manage their mental attitude in order to maintain confidence in the face of uncertainty; discipline in the midst of randomness. Maintaining a confident mental attitude is a skill that can be learned. Top athletes practice it, they call it the zone. Top traders can practice it too.
To Mater the Market, Master Yourself
Whatever your level of intelligence, education and success in life, learning to trade for a living is likely to be one of the most difficult challenges you will ever face. Reflecting on your trading psychology is an important element of your performance.
- Manage Emotional States
You will not be in the best position to make a good decision when any of the above apply to you. Nobody is forcing you to make a trade. Trading discipline is as much knowing when not to make a trade as when it is a good time to initiate a trade. There is no rule of success that says you have to trade every day or even every week.
- Turning negative emotions to your advantage
When I start feeling giddy or even euphoric about a trade, it is usually a good time to take some profit, moving stops tighter. Learn how your emotions work and use them to your advantage as signals. The example above is usually when I start seeing my profits wither away.
- Don’t watch your P&L
Once the P&L is the primary consideration you are not focused on the trade set-up. This is a sure fire way to enter a trade early or exit early, just watch every tick. Anxiety has no place in a traders mindset.
- Adhere to a Trading Process
All of the pitfalls outlined above are why trading processes and associated risk management techniques exist in the first place. They are meant to protect you and you’re P&L.
Creating a Trading Plan – Every trade starts before the opening bell, with a clear plan that is two sided. You must have your size and risk pre-determined to make your decision making in the moment easy. Now where you are wrong and take a loss no rationalizations.
Review Your Performance – Reviewing performance helps you understand your edge, helps you to maintain the right mindset, and helps you be psychologically prepared to do business. Know what your winning formula is and repeat it on every trade.