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Trading psychology is a variable that alltraders—regardless of their preferred markets or trading objectives—will needto actively pay attention to. Even if a trader is highly reliant on hardnumbers or technical indicators in order to make their decisions, the relevanceof trading psychology should not be overlooked.
Trading psychology, as the term implies, can be defined as “the emotions and mentalstate that help dictate success or failure in trading securities.” Generallyspeaking, there are three different emotions that can influence a trader’sdecision-making process. These emotions include fear, greed, and regret.
Theeffects of trading psychology can cause traders to exit trades too early andmiss out on potential profits. Trading psychology can cause traders to hold aposition for far too long and end up losing more than is necessary. At the sametime, under the right circ*mstances, the effects of trading psychology canactually be beneficial.
Inthis article, we will discuss the most important things to think about whenaddressing the effects of trading psychology. By actively accounting for every variable that may be affectingyour trading performance, you can develop a powerful trading strategy that willhelp you achieve your financial goals.
Understanding Greed, Fear, and Regret
OnWall Street, greed often causestraders to hold long positions and try to keep earning money. During bullishmarket conditions (like we witnessed in most of2019),traders that are greedy and have higher risk tolerances will generally be ableto earn more money. However, there are also plenty of times when greed isundeniably a bad thing. If the market is declining, traders that refuse to cuttheir losses will end up holding highly untenable positions.
Fear,generally speaking, is the exact opposite of greed. If a stock has begun toexperience 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 sometraders to control their exposure to risk—something that can be quitebeneficial when markets are generally bearish—fear also limits a givenportfolio’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
Mosttrading strategies can fall into one of two possible categories. Active trading strategies will require traders to identify specific stocks, use various technicalindicators, and try to speculate whether individual assets are likely toincrease or decrease in value. Passivetrading strategies, on the other hand, assume that markets as a whole aregenerally smarter than any given trader. Passive traders will invest indiversified securities, such as index funds, hedge funds, and other comparableoptions.
Naturally,active traders are the ones that will need to pay attention to their psychologythe most. When a trader begins making several profitable traders in a row, theymay be convinced they have a sort of “special touch” that makes theminvincible—greed is especially common among high-risk traders. At the sametime, traders that are on a losing streak may also allow their fear to causethem to overlook trades they would ordinarily find desirable. Rather thanrelying on logic and tangible numbers, these traders are governed by theiremotions.
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
Inorder to develop an effective trading strategy, the first thing a trader willneed to do is recognize their personal trading profile. Any trader that hopesto earn stronger returns will need to be willing to take higher risks. At thesame time, any trader that hopes to minimize their exposure to risk will needto 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 tradingpsychology. For example, issue stop orders inadvance can help them make decisions before any psychology effects havebegun to accumulate. As time goes on, their exit ratios can be adjusted (forexample, switching from 2:1 profit to loss to 3:1 profit to loss), but it willstill 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. Trading can cause mental stress. If you need the advice to cope with this situation, click here.
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.
Also read: Trading Will Become Easier Over the Period of Time
Conclusion
Tradingpsychology 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 undesirabledecisions. However, by actively addressing the effects of trading psychologyand taking measures to control them, you can become a successful trader—both inpractice and on paper.
