The Importance of Psychology in Trading

Some general thoughts

When it comes to trading, another aspect of utmost importance is purely psychological in nature. Psychology refers to the way every trader perceives what is happening in the financial markets and how this perception can be influenced by emotions and one’s susceptibility to different biases.

There is a tendency for the majority of market participants to experience a similar set of thoughts and emotions while engaged in trading; however, there is a clear difference between how those who are losing money think and how those who are making profits think.

Many traders strongly believe that a reliable and tested trading system is the only thing they need to perform successfully in the market. Outperforming the market sometimes appears not to be such a hard task, but traders tend to devote a huge amount of their energy, effort and time to achieving it by using a particular strategy or a combination of strategies. Therefore, they pay far less attention to overcoming other barriers – psychological ones such as emotional extremes. These extremes are almost always the factors that obstruct traders from making their own analyses and decisions.

We should note something else. There is a reason why many individuals who push themselves into the world of Forex trading eventually experience severe losses. The reason for this lies in their expectations, which, in most cases, are quite unrealistic. Many people tend to believe that only a month or two of trading will enable them to leave their full-time jobs. Others believe that a deposit of USD 1,000 may grow to USD 100,000 or more in just a few months.

Such far-from-reality expectations usually create a completely incorrect mindset and fuel a pressing need to make profits by any means necessary in the Forex market. As this need grows, a trader inevitably becomes controlled entirely by his or her emotions – a 100 % sure way to go broke. It is this combination of wrongly defined trading objectives and unrealistic expectations that, in most cases, leads to ruin.

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Emotions in trading

Emotions are your worst enemy in the market, and learning how to diminish their impact on your decision-making is a tough task that usually requires years of experience. There are five common emotional mistakes that traders make, and all of them can lead to massive losses, so you should do your best to overcome them. They are greed, fear, revenge, euphoria and pride. So, let us turn our attention to each of them.

Greed

Greed is probably your worst enemy and is just as hard to overcome as fear itself. Greed is a typical human trait – one on which the whole human society is based, to some extent. Each person has an instinctive desire to do something better – even the laziest people – and to try to get a little more out of a situation. Although a small, healthy amount of greed in life can be stimulating, there is no place for it in trading; even the desire to squeeze an extra 10 pips can be devastating if an unexpected price reversal occurs.

There is a very popular old saying among investors that “pigs get slaughtered” while bulls and bears make money. It means that the “greedy pigs” are bound to lose their money eventually because they tend to hold winning positions for too long in an attempt to milk every possible pip out of the market. And this doesn’t come cheap; it carries a huge risk of being whipsawed by the market.

Another common mistake associated with greed is that people add too much to a position simply because the market has moved in their desired direction, instead of basing their decision-making on sound analytical reasons. It is also very common for inexperienced traders to risk too much right from the start instead of scaling in and using a proper money-management system. Another frequently observed mistake driven by greed is that novice traders choose high leverage from the outset, drawn by the prospect of high returns. Well, you can guess how that ends.

Euphoria

Euphoria is a form of greed that arises after a trader has experienced a winning streak or achieved a single large win. It builds excessive optimism and confidence, often luring you into opening and holding many new positions – usually in the same direction as the previous winner – which can, however, end badly.

This is why some traders experience their biggest losses right after they have had a good winning streak. It is very tempting to try to ride the winners’ wave immediately after you have earned some profit, but you must keep your feet on the ground and draw a thick line between reality and the feeling that everything you touch will turn to gold.

Fear

Fear is another overwhelming feeling – completely natural for every living creature – but unwelcome in a trader’s mindset. Fear can cause you to miss out on profits by exiting a winning position early, to miss opportunities by not entering a position at all, or to incur losses when you exit a losing position too early and do not give it a chance to turn profitable, as your sound trading strategy had predicted.

Like animals, people feel fear when they encounter a source of threat – in this case, the threat of losing money. Fear itself can wreak havoc on your trading capital, and allowing it to get the better of you will lead to further negative emotions such as anger, revenge and hatred. Overcoming fear requires a great deal of practice, discipline and preparation.

Fear often arises after a long series of losses, especially after having to swallow a loss larger than you can emotionally absorb. By thinking ahead before entering a trade and knowing how he or she instinctively reacts to stressful situations, a trader can learn to isolate fear during the trading session and move past it.

As mentioned, a market participant might be afraid to hold a position open for fear of losing money. In many cases, an inexperienced trader will exit a winning trade too early for fear of being blown out by a price reversal. This is the opposite of greed and needs to be fought in the same way – by relying on your thoroughly tested trading strategy. This includes placing appropriate protective stops and price targets before you enter the position, ensuring that your trade plan will not be affected by emotions that arise during the trade.

The other two types of losses fear can cause – missing opportunities by not entering a position at all and incurring losses when you exit a losing position too early – are based on the same principle and are combated in the same way: by remaining neutral and sticking to your predetermined strategy. One of the most efficient ways to overcome fear is never to risk more money than you are willing to lose with a cool head. If you have no problem with losing, let us say, 20 dollars and you risk only that amount, you should, generally, remain calm during the session no matter what happens.

Revenge

As mentioned above, revenge very often follows fear and the negative results it carries with it. For example, a trader might become agitated after missing a very good entry opportunity because he or she decided not to enter due to fear of losing money.

“Revenge trading” commonly occurs after a trader experiences a loss, especially if it is greater than he or she can usually handle. This once again calls for using a proper money-management system.

Many market participants enter revenge mode after a trade they were sure would be successful goes wrong, causing them to lose money. Two things should be considered here: 1) nothing is certain in the markets; 2) protective stops are your friend.

When they become agitated, inexperienced traders will try to recoup their losses by jumping straight back into the market. However, because the decisions they are about to make are based on emotion, it is very likely that they will fail and will probably incur an even greater loss than the previous one. Revenge can be associated with overconfidence, which stems from pride.

Pride

Pride is another major issue some traders encounter. It reflects behaviour in which traders refuse to acknowledge or recognise their mistakes, thus preventing them from learning and improving. Basically, the stubbornness of these traders drags them down and, instead of getting better at what they are doing, they simply worsen their performance.

Failing to acknowledge your mistakes and being overconfident in your capabilities lead to poor risk management. Without sound risk management, as we know, you are doomed eventually to fail. That is why – notice the pattern – you must at all costs remain neutral and stick to your predefined trading strategy.

Effective trading mindset is of critical importance

First, a trader needs to establish a trading plan. This includes devising a plan to amass knowledge of the area (Forex trading), attending trading seminars, taking online courses and spending as much time as possible conducting research on the matter. One should take the time to study different price-chart variations, read interviews with managers, policymakers and experts, follow day-to-day analysis in specialised media and even conduct macroeconomic, corporate or industry analysis of one’s own. The more knowledge one obtains, the easier it will be to manage issues such as fear.

Second, a trader needs to know his or her trading strategy down to the last detail. Mere acquaintance with the strategy is not enough. Precision and complete awareness of the market signals required to justify entering a position are essential.

Third, a trader needs to implement strict risk management. If one does not manage risk on each trade, the likelihood of giving in to emotions increases. The best way to protect yourself against becoming a highly emotional trader is to risk only the amount you feel completely comfortable losing. This should be applied to every position you enter. Expecting a loss on any trade gives you awareness that there is always a chance such a scenario will develop, that something unexpected can occur and adversely affect your position.

Fourth, an investor should abstain from over-trading. There is no need to trade excessively. You should simply know your trading edge (strategy) inside out and enter trades only when you are certain that an opportunity is present.