In financial markets dominated by vast mounts of data, sophisticated analytical programs and quantitative strategies, concerns about the psychological aspect of trading may seem quaint.
However, in reality an understanding of trading psychology has never been more important.
It is precisely when we forget to question our motivations and emotional state that we become vulnerable to poor decision-making.
While the digitization of trading may have transformed many aspects of the profession, little has changed in the realm of trading psychology.
The old lessons learned the hard way over decades of experience are still as applicable today as they were when they were first learned.
In this guide we will briefly examine the four strongest emotions in trading psychology:
- FOMO
- Fear
- Greed
- Hope
Then we will look at what traders can do to master their emotions and ensure that they are making clear and informed decisions every time.
How The Fear of Missing Out (FOMO) Can Ruin Judgement
The fear of missing out usually occurs when a stock is a making a big move and you missed it. This can lead to chasing an entry which is never a good trading decision because you will end up with a poor entry price and as you are caught up in the though of missing out you forget to manage your trade and risk.
The fear of missing out is driven by a desire to be a part of a good thing, even when all signs suggest that it is not a wise investment.
FOMO is so pernicious because we see other people succeeding, even if they are taking unjustifiable risks to do so, and we have a natural urge to join in.
The more wildly successful other people are, which is usually directly correlated with the amount of risk they are taking on, the stronger the urge to join in.
FOMO is usually harder for new traders to grasp because they haven’t been burned as many times as someone who has been trading the markets for a while.
The best way to deal with FOMO is to have rules in place and if you break them then you need to have some kind of punishment like no trading for the rest of the day.
You can’t make trading decisions based on emotions no matter how much money you see other traders making on a crazy run. There will always be other opportunities so stick to your rules!
No Fear!
Fear is a broad sense of unjustified panic that occurs when market participants as a whole take a generally pessimistic view toward the financial, economic and political future.
Under a climate of fear, traders focus on and amplify any bad news, and are quick to close out long positions or open new short positions.
A climate of fear in the markets is self-reinforcing: as more people become afraid and sell, the greater the overall sense of fear becomes.
Under a climate of fear it is very difficult for an individual investor to make rational investing decisions based on reasonable expectations of the behavior of the market as a whole.
Fear is common in traders because we don’t know what’s going to happen after we enter a trade.
We have an idea of what will happen but we don’t know this with 100% certainty and when you have a lot of money on the line and don’t know what’s going to happen, it can cause fear and anxiety.
A good to way to counterbalance fear is by trading within your means and setting an acceptable loss amount. This way you know, before you even enter the trade, that you are only risking a certain amount.
This takes some of the uncertainty out of the trading process because now we know what is on the line. Every time I enter a trade, I tell myself that I may lose money and that’s OK, just don’t lose more than my predetermined amount!
Another way fear gets in our way is when we are trading with too much size that it makes us uncomfortable and fearful of losing too much money or even worse, blowing up our account. That’s why sizing is so important.
Start off small and gradually work yourself up to larger size. Just because you had a solid month doesn’t mean you should go from trade 500 shares to 5,000 shares.
Greed Is Good…Or Is It?
Greed is the other side of the coin to fear. Greed is also similar to the fear of missing out, but more focused on a broader outlook instead of some smaller segment of the market.
Under greed, economic, political and financial news is viewed extremely optimistic, and bad news is ignored of waved-away as unimportant. Greed creates a self-reinforcing cycle of rising asset prices and positive outlooks.
Traders become so accustomed to rising asset prices, that they begin to ignore obvious signs of risk or negative outcomes.
Trying to squeeze every last penny out of a move is a surefire way to give up profits and even lose money. The best way to handle greed is just like how you would handle fear.
Set predetermined profit targets and when they hit, cash in! It’s not rocket science you just have to be disciplined enough to follow your rules!
Hope
Hope in trading psychology is the unrealistic expectation of something good happening.
Traders can be hopeful at the height of a gain or the lows of a loss, but in all cases their desire for something to happen trumps their ability to rationally foresee outcomes.
Hope is a very natural human emotion, particularly in matters involving chance, risk and odds.
The mere desire to want to believe in something is often enough to cloud our judgment and lead us to make poor decisions based on the hope that things will turn our way.
How to Master Your Emotions
While mastering your emotions in trading is a never-ending battle, the basic framework for tackling the problem is actually quite simple.
Your emotions run wild when they are given the space to dominate your thinking, which is why professional traders always use a strict trading system that helps to contextualize their decisions and keep their emotions in check.
Traders can rely on a tried and tested trading strategy to help them gauge and control their emotional state.
A regimented trading system offers an anchor of proven reason that traders can rely upon when attempting to interpret market information and their own emotions.
Any effective trading strategy is composed of various rules that help to frame all investment decisions.
Rules for Identifying Trades
The rules for identifying trades are useful for keeping traders on track and focused on those areas where their knowledge and experience gives them an advantage.
These rules are particularly useful when it comes to controlling for greed and the fear of missing out, as it keeps traders in a safe area that they understand instead of chasing profits in asset classes that are alien to them.
It’s weird to say, but you need to be like a robot when trading. You have to be systematic and rely on your trading process and rules to be your guidelines for success.
Rules for Executing Trades
The actual opening and closing of positions is always the most difficult and stressful aspect of trading. Even the most well-researched trades can go poorly if the trader is overly emotional when executing trades.
Having a set of strict rules for how and when to execute trades is essential to maximizing the profits from good ideas and minimizing the losses from trades gone wrong.
An extensive use of advanced orders, such as profit-takers and stop orders, is an important element of a strong trade execution system.
When I first started trading, if I broke any of my rules I would have to stop trading for the day and make myself review my trading process. Eventually I broke my rules less and my trading improved.
Now every once and a while I will break a rule but I have the experience and know-how to correct it and get back on track.
Rules After You Trade
Whether you just met your weekly profit target in one trade or wiped out two day’s worth of work, it is always wise to have a system for cooling down after one trade before moving on to the next.
Every trade will color your emotional state, so the best traders know how to cleanse themselves of the lingering emotions of the last trade before moving on to the next one.
Trading Psychology: Master Your Emotions
While many traders may be technically skilled, the greatest traders are masters of personal discipline first and trading knowledge second.
A knowledge of the common pitfalls in trading psychology and a strict set of rules for trading are both essential to achieving lasting success in trading.
With these in place, it is simply a matter of putting in the time and effort to become the master of your emotions and a master of trading.