Trading psychology is a variable that all traders—regardless of their preferred markets or trading objectives—will need to actively pay attention to. Even if a trader is highly reliant on hard numbers or technical indicators in order to make their decisions, the relevance of trading psychology should not be overlooked.
Trading psychology, as the term implies, can be defined as “the emotions and mental state that help dictate success or failure in trading securities.” Generally speaking, there are three different emotions that can influence a trader’s decision-making process. These emotions include fear, greed, and regret.
The effects of trading psychology can cause traders to exit trades too early and miss out on potential profits. Trading psychology can cause traders to hold a position for far too long and end up losing more than is necessary. At the same time, under the right circumstances, the effects of trading psychology can actually be beneficial.
In this article, we will discuss the most important things to think about when addressing the effects of trading psychology. By actively accounting for every variable that may be affecting your trading performance, you can develop a powerful trading strategy that will help you achieve your financial goals.
Understanding Greed, Fear, and Regret
On Wall Street, greed often causes traders to hold long positions and try to keep earning money. During bullish market conditions (like we witnessed in most of 2019), traders that are greedy and have higher risk tolerances will generally be able to earn more money. However, there are also plenty of times when greed is undeniably a bad thing. If the market is declining, traders that refuse to cut their losses will end up holding highly untenable positions.
Fear, generally speaking, is the exact opposite of greed. If a stock has begun to experience some minor losses, a fearful trader might decide to immediately “jump ship.” They may even exit early during market rallies, knowing that, eventually, the market will begin to slow down. While fear empowers some traders to control their exposure to risk—something that can be quite beneficial when markets are generally bearish—fear also limits a given portfolio’s earning potential.
Lastly, regret is a hazard that all traders will need to account for. Regret—known as the “fear of missing out” and various other names—will often push traders to enter into a position, even after the window of opportunity has already closed. In December 2017, many traders saw Bitcoin had inflated in price to nearly $20,000. Regretting their decision to forego Bitcoin when it was trading under $2, some of these traders decided to heavily invest while the market was at its high point. Had they exercised a value investing strategy, rather than simply looking backwards, these traders could have avoided the 85 percent value loss that inevitably followed.
Passive versus Active Trading Strategies
Most trading strategies can fall into one of two possible categories. Active trading strategies will require traders to identify specific stocks, use various technical indicators, and try to speculate whether individual assets are likely to increase or decrease in value. Passive trading strategies, on the other hand, assume that markets as a whole are generally smarter than any given trader. Passive traders will invest in diversified securities, such as index funds, hedge funds, and other comparable options.
Naturally, active traders are the ones that will need to pay attention to their psychology the most. When a trader begins making several profitable traders in a row, they may be convinced they have a sort of “special touch” that makes them invincible—greed is especially common among high-risk traders. At the same time, traders that are on a losing streak may also allow their fear to cause them to overlook trades they would ordinarily find desirable. Rather than relying on logic and tangible numbers, these traders are governed by their emotions.
Passive traders, while generally protected from some of the effects of trading psychology, will also need to recognize the risks created by their own ego. By trusting the market, they can “power through” potentially intimidating bearish markets. Again, rather than looking backwards and seeing what has happened, these traders will benefit from looking forward and determining what is likely to happen in the future.
Avoiding Risk, Pursuing Strong Returns
In order to develop an effective trading strategy, the first thing a trader will need to do is recognize their personal trading profile. Any trader that hopes to earn stronger returns will need to be willing to take higher risks. At the same time, any trader that hopes to minimize their exposure to risk will need to be willing to accept a lower rate of return on their positions.
Fortunately, there are quite a few things traders can do to address the effects of trading psychology. For example, issue stop orders in advance can help them make decisions before any psychology effects have begun to accumulate. As time goes on, their exit ratios can be adjusted (for example, switching from 2:1 profit to loss to 3:1 profit to loss), but it will still be crucial to issue stop orders, nevertheless.
Adjusting Your Strategy for New Markets and Securities
Trading psychology is present in every market. In high-risk markets (such as penny stocks, cryptocurrency, gold, and various others), allowing greed, fear, and regret to dictate your decisions will be even more tempting than usual.
Traders that hope to effectively manage the impacts of trading psychology will need to rely on objective technical and fundamental indicators when making any decisions. Don’t sell Bitcoin just because you “feel” that it is about to experience a price swing; do it because the Relative Strength Index or Bollinger Bands are indicating this is actually likely to occur. The more you can do to change your trading strategy from a guessing game into a tested science, the more likely you will be able to enjoy consistent results over time.
Trading psychology is a very important part of any long-term trading strategy. Fear, greed, and regret can often cloud our judgment and cause us to make undesirable decisions. However, by actively addressing the effects of trading psychology and taking measures to control them, you can become a successful trader—both in practice and on paper.