Intermediate Level

Learn more complex tools and techniques that will help you in trading.

Lesson 9: Trading Psychology

There are
many skills needed for traders to be effective in the financial markets— the
ability to understand the economics of a business and the ability to determine
the course of the stock trend are two of them. But neither of these technical
skills is as critical as the mind of a trader: the ability to control passion,
think quickly, and exercise discipline —what we might call trading psychology.

The
psychological aspect of trading is of the utmost importance. Traders often have
to think quickly and make quick decisions, moving in and out of stocks in the
short term. We need a certain presence of mind to achieve this. We do, by
default, need consistency, so that we adhere to previously established trading
strategies and know when to book profits and losses. Emotions just can’t get in
the way.

Understanding Fear
If traders get bad news about a certain stock or the general market, it’s not
uncommon to get frightened. They can overreact and feel compelled to liquidate
their holdings and go to cash or refrain from taking any risks. If they do,
some losses may be avoided, but gains may also be lost.

Traders
need to know what fear is: a natural reaction to what they see as a threat— in
this case, to their benefit or money-making ability. Quantifying fear could
help, and traders should consider thinking about what they’re afraid of and why
they’re afraid of it.

Through
addressing this problem ahead of time and understanding how to automatically
respond or interpret those events, a trader may expect to isolate and recognize
certain emotions during a trading session, and then try to focus on moving past
the emotional response. This is not easy, of course, and may take place in
practice, but it is important for the safety of the portfolio of investors.

Overcoming Greed

There’s an
old saying on Wall Street that “pigs get slaughtered.” This adage
applies to greedy investors holding on to winning positions for too long,
seeking to get every last tick. Greed can be devastating to recover from,
because a trader is always at risk of getting whipsawed or blown out of a spot.

Greed isn’t
easy to overcome. It’s often founded on an impulse to try to do better, to try
to get a little more. The trader must learn to recognize this instinct and
build a trading plan based on rational business decisions, not on irrational
impulses or potentially harmful instincts.

Setting Rules

To get
their heads in the right place before they experience the emotional pinch,
traders need to set rules. They should set out criteria based on their
risk-reward appetite for when they enter a trade and exit it — whether through
a gain goal or a loss stop — to get emotion out of the equation. In addition, a
trader may decide to purchase or sell security as a result of certain events,
such as particular positive or negative earnings or macro-economic news.

Traders
would also be wise to consider setting limits on how much they are willing to
win and lose in a day. If the gain target is hit, they’ll take the money and
run, and if losing trades reach a set cap, they’ll fold up their tent and go
back, preventing more losses and surviving to trade another day.

Doing Research and Review

Traders
should know as much as they can about their area of interest, educate
themselves and, if possible, attend business seminars and sell-side
conferences. It also makes sense to prepare and commit as much time as possible
to the research process. It involves reviewing maps, speaking to management (if
applicable), reading business papers, or doing other background work (such as
macroeconomic analysis or market research) to speed up the start of the trading
session. Knowledge can help a trader overcome fear, so it’s a useful tool.

In
addition, it is critical that traders remain flexible and consider
experimenting with new instruments from time to time. For example, they might
suggest using risk mitigation tools or setting stop losses at different
locations. One of the best ways a trader can learn is through experimentation
(within reason). Such experience may also help to reduce psychological factors.

Ultimately,
traders must periodically evaluate their results. In addition to evaluating
their returns and individual positions, traders will consider, among other
items, how they have planned for a trading session, how up-to-date they are on
the markets, and how they are doing in terms of continuing education. Such
periodic appraisal can help a trader correct mistakes and change bad habits,
which may help to improve their overall returns.

The Bottom Line

While it
is critical for a trader to be able to read a balance sheet or chart, there is
a psychological component to trading that should not be ignored. Being mindful
of how fear and greed can influence trading, practicing discipline,
establishing trading rules, experimenting, and regularly self-examination is
critical to a trader’s success.