Trading Psychology

Beginner
AvramisDespotis
1 Lesson
6 Hours

Trading Psychology

Welcome to Trading Psychology! In this video, you will learn about the correct mental approach towards trading, the human mind, fear and greed, the need to always be right, and creating a trading plan.

Overview

After spending enough time learning, you should be able to develop your trading system and have your money management rules set up. You will see your method work time and time again, and you will see what happens when you don’t follow your money management rules. Now is the time to add the third and most important piece of the puzzle – trading psychology.

The Correct Mental Approach

Trading psychology and the correct mental approach are key components of successful trading. Trading psychology is the control of the trader’s fear and greed. In general, it’s the discipline to follow your method and stick to your money management rules. Without discipline, all the best-laid plans can quickly become meaningless. It all starts with the human mind.

The Human Mind

The human mind is made up of two parts, Psychologists call it the conscious mind and the subconscious mind. Another way to describe the conscious mind is as the analytical mind, the calculator, the computer that makes rational decisions. The subconscious mind, on the other hand, can be described as the emotional or even crazy mind that makes irrational decisions.

The two parts of the human mind are like an iceberg. The 10% that you can see on the surface is our conscious mind while the 90% that is below the sea level is our subconscious mind. Our subconscious mind is the part of the brain that stores majority of our thoughts, feelings, and habits – it helps run our lives on autopilot. “Bad” habits are formed through repetition and are printed in the subconscious mind, making it extremely difficult to do what you know you should, and want to do using your conscious mind. These thoughts occur on a subconscious level, where the trader does not even realize this is happening until someone else who can see it brings it to their attention.

Bad Trader Habits

Three of the most common “bad trader habits” are (1) fear and greed, (2) the need to be always right, and (3) the lack of a trading plan.

Fear and greed are instincts that evolved long ago when we lived off the land as hunter-gatherers and took refuge in simple shelters like caves. Although very useful then, many do not work so well in modern man-made environments like trading.

The need to be always right is caused by the educational and political system we have gotten used to wherein when we do something right, we get rewarded; and when we don’t, we get penalized – which makes accepting difficult.

The lack of a trading plan stems from the repetition of bad habits, leading to poor execution and straying away from the chosen trading system.

In the next section, we will go through the reasons why we have these bad trading habits and illustrate possible solutions.

Fear and Greed

Fear in trading primarily takes one of two forms: (1) the fear of loss and (2) the fear of missing out. The fear of losing can make someone hesitate to trade or to hang on to losing trades because of the prospects of another loss. The fear of missing out is another form of fear that compels people to abandon their rules and enter the market before they get the right signal from their system; causing them to take every trade they see, resulting in more frequent and bigger losses than their system would produce.

Greed is the motivation for overconfidence. Dreams of "making it big very fast" in trading can cloud a trader’s mind. Again, they abandon the rules of their trading system in the hopes that more money will come their way.

Fear and greed are causing traders not to follow their method and money management rules. This is one of the most common factors holding investors back from making the money they could truly be making.

Fear

Fear is a chain reaction in the brain that starts with a stressful stimulus, also known as the fight-or-flight response. The stimulus could be a spider, a knife at your throat, an auditorium full of people waiting for you to speak or for a trader the prospect of loss. The process of creating fear takes place in the subconscious brain and is entirely unconscious.

Scientists performed an experiment in which they would play a tone, then immediately apply a shock to the metal floor of a rats' cage. It was classical conditioning, and it didn't take long for rats to brace themselves for the shock as soon as they heard the sound. At that point, their brain paired the sound with the shock, and the sound created a fear response. The researchers then began the process of fear-extinction training, in which they made the sound but did not apply the shock. After hearing the sound very often without the shock, the rats stopped fearing the noise.

Tips

Here are some tips for managing your fear and greed:

  • STOP TRADING FOR A DAY
    Learn about the thing you fear. Loss? Missing out? Ridicule? Uncertainty is a huge component of fear. Developing an understanding of what you're afraid of goes a long way toward erasing that fear.
  • TRADE SMALLER AMOUNTS
    If there's something you're afraid to try because it seems scary or difficult, start small and take it step-by-step. Slowly building familiarity with a scary subject makes it more manageable. So as a trader, trade in smaller amounts.
  • FIND A MENTOR
    Find someone who is fearless. If there's something you're afraid of, find someone who is not afraid of that thing and spend time with that person. Take that person along with you when you try to conquer your fear.
  • ADMIT IT
    Talk about it. Sharing your fear out loud can make it much less daunting – admit you are afraid or have gotten too greedy.
  • ONE DAY AT A TIME
    Worry less about the bigger picture and try to focus on each successive step. If you're afraid of missing out, don't think about missing 50 trades – instead, think of it as missing small and low probability trades.

The mind is conditioned to strive to be correct in any way it can, thus, being wrong is considered extremely bad. An example would be a trader who keeps holding on to a losing position hoping that the market turns around so his losses don’t become real. If the market turns in the trader’s direction, then the trader obviously made the right decision, and the idea of being correct is reinforced. Alternatively, when a position starts raking in profit, they are fast to take their profits and close the position. By closing the position in profit, they feel they have made the correct decision. This is one of the main reasons why beginners tend to cut their profits early while allowing their losses to continue.

The Need to be Always Right

Our education system has made us accustomed to the habit of being rewarded when we do things correctly. People are conditioned to believe that they are doing something right when they get the right answer, and they are doing something wrong when they get the wrong answer. This long-term social conditioning creates the need to be always right, thus, an inability to accept loss, as a loss means you are wrong. In trading, the reward system of the market goes against this need to be always right; causing traders to fail. Loss generates powerful emotions such as fear, uncertainty, apprehension, and self-doubt.

However, successful trading is not only dependent on being accurate. Even most professional traders say they are correct less than half of the time. Profitable trading is based on balancing risk and reward. It is about allowing profits to run and closing losses early to prevent them from getting bigger. As the saying goes “amateurs care about being right, professionals care about making money”.

Being right and being profitable are two different things when it comes to trading. They are not linked in the way they are traditionally linked, like other things in life. Adapting to this is one of the biggest challenges for traders. The first step in handling them is identifying the psychological barriers, and then changing our habits. We have seen many traders go from big losses and stressful days, to steady profits with calm and consistency after resolving these psychological issues. With time and practice, so can you.

You are in a market where you can do everything right according to your method and still lose. The solution is to take a reality check. Losing is part of the game. The possibility of losing is always there. Bottom line: traders do lose. How much and how often is what distinguishes great traders from those who will always struggle.

You can learn how to accept losses by redefining the meaning of loss. If you equate it with failure, it will sooner or later take its toll; but redefining it will help you move forward, improve your trades, and cope with possible losses. Consider losing as positive in the sense that it will improve your next trades. If you prefer, consider losses as business expenses – like how a restaurant throws away unsold food but still remains profitable.

Creating a Trading Plan

Everyone needs a trading plan. This is a MUST for all traders, regardless of their trading experience. As the saying goes, “If you fail to plan, you’ve already planned to fail”. Having a trading plan before starting to trade is much like having a map before starting to travel. Without a trading plan, you would be lost, leading to relying on rumours and gut feel for your trades. If you are not doing well in trading, it may be due to a lack or complete absence of a trading plan. If you are trading without a plan, you don’t know where you’re going wrong and you won’t know how to fix it. A trading plan outlines instructions of how to react under different possible scenarios. Through repetition, this process starts to build the good habits needed to become one with the trading plan, until following your trading plan becomes second nature. Trading psychology is what guides traders to follow and execute their plan.

There is only one rational reason to trade—to make money and not to have fun. Money attracts traders to the markets; but in the excitement of a new game, one can often lose sight of the goal and trade without a plan or trade purely for fun. Trading without a plan takes the responsibility away from the trader and leaves it to chance. When one trades without a plan with countless variables, it's easy to take credit for trades that turn out to our liking, because there was some method present. it’s also very easy to avoid taking responsibility for the trades that didn't turn out the way we wanted, because there's always some variable we didn't know about, and therefore couldn't take into consideration beforehand.

The solution is to have a trading plan and follow it. A trading plan consists of 3 parts: (1) early signals, (2) exit signals, and (3) money management.

Entry signals are conditions that need to be met in order to enter into a new trade. Exit signals are reasons for closing a trade, either because a target was reached or a stop loss was triggered. Money management is the amount to risk on every trade. Using a trading plan makes enforcing discipline easier. Having a trading plan and being prepared for your trades helps keep emotional responses to trades at a minimum.

In the next video, we will talk about the mindset for success. Thank you for watching!