What Are the Basics Of Trading Psychology?
The field of active trading is a challenging, fast-paced environment with nearly infinite possibilities and pitfalls. The odds are seemingly stacked against active traders in the marketplace, with studies suggesting that upwards of 80% consistently lose money and only 1% achieve predictable, long-term profitability.1)Retrieved 28 June 2016 http://faculty.haas.berkeley.edu/odean/papers/returns/Individual_Investor_Performance_Final.pdf
With four out of five traders showing regular losses, it’s a wonder anyone is willing to pursue a career in the trading industry. After all, it’s not typical for an individual to invest time and money into a business that has an 80% chance of failing. So, why the attraction to active trading as a profession?
The answer lies in the benefits that success in the marketplace can provide to prosperous traders. Financial independence, self-empowerment and an escape from an unsatisfying career are a few perks enjoyed by those who beat the odds and grasp the brass ring.
The Challenge Of Trading
Active trading as a profession presents many challenges to an individual entering the marketplace for the first time. Statistics are not encouraging, with most empirical evidence suggesting that an individual’s trading career will be brief and expensive.
Longevity in the marketplace among new traders is predominantly fleeting. Academic studies focused upon the length of time new traders remain active show that nearly 40% last one month in the market, and only 7% remain active after five years.2)Retrieved 28 June 2016 https://faculty.haas.berkeley.edu/odean/papers/Day%20Traders/Day%20Trading%20and%20Learning%20110217.pdf
In addition to the short trading career, a novice trader’s entrance into the financial markets can also prove expensive. The amount of monetary loss sustained by a new trader during his or her introduction into the marketplace can vary wildly, and is ultimately dependent upon how much capital is at the trader’s disposal. In addition, reckless implementation of leverage by an inexperienced trader can rapidly turn a manageable drawdown into catastrophe.
While it’s true that active trading produces many more losers than winners, the possibility of success does exist. Personal anecdotes of financial gain, the impressive track records of famous investors and profiles of day traders who took small amounts of venture capital and subsequently built fast fortunes are easily found through some basic research of the trading industry.
Perhaps the most compelling evidence that trading success is possible are the statistics surrounding the trading practices of profitable traders. Studies have shown that the 1-2% of traders who achieve long-term profitability account for 12% of all day-trading activity.3)Retrieved 28 June 2016 https://faculty.haas.berkeley.edu/odean/papers/Day%20Traders/Day%20Trading%20and%20Learning%20110217.pdf This relationship illustrates that successful traders have found a method of conducting trade that creates an “edge” that can be applied repeatedly to the marketplace. Through consistent and calculated action, these traders are able to regularly prosper.
The psychological makeup of each trader has an enormous bearing on whether or not success in the marketplace is achieved, or even remotely possible. Managing one’s emotions when confronted with market-induced adversity presents many challenges to the active trader and is a critical aspect of performance.
Fear and greed are the two emotions that exert the most influence upon an individual’s performance in the marketplace. Automatic emotional responses, such as these two, have been scientifically shown to “short-circuit” the more complex decision-making processes involved in active trading.4)Retrieved 28 June 2016 http://www.nber.org/papers/w11243.pdf Unless properly addressed, fear and greed can be drivers of emotional decision making and directly responsible for preventing the consistent application of sound trading methodology.
Fear functions as a security device and is an important part of survival. Conversely, in the trading environment, fear proves to be a performance inhibitor.
In the arena of active trading, there are two classifications of fear, each with unique negative impacts upon trading performance:
- Fear of failure: Fear of failure associates personal self-worth with the result of a losing trade and loss of capital. As a result, increased pressure brought on by perfectionism in addition to the unwillingness to execute trades in apprehension of loss are common problems related to a trader’s fear of failure.
- Fear of success: Fear of success is a bit more difficult to comprehend, as it runs counterintuitive to most people’s views toward achievement. Self-sabotage and giving back profits, known as “donating” to the market, are performance detractors that arise from a trader’s fear of success.
Without a mechanism by which to manage fear and the resulting anxieties, a trader is likely to experience high stress, inner conflict and an overall negative experience in the marketplace.
In the world of trading, success is universally measured through the amount of money in one’s trading account. Score is kept in dollars and cents, thus greed in active trading is centered on the accumulation of hard currency.
Greed is a determinant of a wide variety of practices that are detrimental to profitable trading. A few of the most common pitfalls are:
- Overtrading: Overtrading can be attributed to greed in that the desire to make money encourages taking trades that are outside of the adopted methodology. Impulsive trading is often the result, with the trader ignoring pre-set rules in favour of chasing profit or making up for losses.
- Aggressive risk taking: In order to make more money and satisfy greed, a trader may adopt risk parameters that exceed available resources. Taking abnormally large positions and engaging in reckless money management practices are common issues associated with greed.
- Inability to define profit and loss: Profit and loss are key elements of money management that must be defined before each trade is taken. Greed makes this difficult, because the profit targets are often unreasonable and the realisation of a loss delays the instant gratification that a winning trade provides. The result is the tendency to exhibit indecision when taking profits, and reluctance in exiting losing trades.
If greed is left unmanaged and remains a formidable part of a trader’s psyche, periods of sustained success can lead to a feeling of trade-related euphoria, as feelings of overconfidence can lead to aggressive risk taking and hyper-aggressive trade selection.
The influence that greed and euphoria have upon a trader’s psyche can be substantial and harmful to a healthy trading mindset. The task of managing these issues must be honestly addressed in order to overcome the challenges they pose to profitability.
Trading Mistakes And Remedies
There are several common mistakes made repeatedly by new traders. Each one acts in opposition to the achievement of success and profitability. However, given the proper time and attention, each fault can be remedied.
Listed below are a few common mistakes made by new (and some veteran) traders:
- Lack of a comprehensive trading plan: The marketplace is a dynamic arena with nearly limitless possibilities facing an active trader. Without a clearly defined trading plan to use as a point of reference, a trader will operate within the market from a reactionary posture and struggle to stay on the market’s “lead lap.”
- No defined money management strategy: Money management may be the most important facet of trading. If fundamental principles of money management aren’t employed, undue risk may jeopardise the solvency of the trading account.
- Acting on “tips” or “advice”: Making trading decisions on a “hot tip” or “inside information” is often a product of emotional trading. Odds are that the hot tip is a rumor, hearsay or worse. Even if true, there is a strong possibility that the tip has been widely circulated and is already priced into the market.
- Satisfying the desire to be “right” instead of making money: The main goal of actively trading financial securities is to make a profit. At the end of the day, the market is always right, and traders are often wrong. The realisation that one can be wrong about many things and still make money is a difficult idea to accept, but one that is a key part of a healthy trading mindset.
Each of the aforementioned mistakes acts as a potential barrier to a trader’s success and profitability. However, through dedicating adequate time and effort, the frequency of these mistakes can be reduced or eliminated.
Engaging in the following activities and applying them to trading operations can create a mental environment that’s useful in the remedy of trading-related challenges:
- Goal setting: Goals can be an empowering method of measuring trader growth and play an important role in building confidence. Setting realistic periodic goals based on performance and outcome is essential to accurately measuring the relative success of a trading operation.
- Developing trading rules: A set of clear-cut, probability-based trading rules is an important part of defining the dialogue between trader and market. For instance, rules governing trade entry and exit, time of day in which to trade and length of trading session give the marketplace defined limits. During volatile periods, a detailed set of trading rules can serve as a point of reference and provide much-needed context to the chaos.
- Implementing a money-management strategy: As stated earlier, money management is a key aspect of profitability. A comprehensive money-management strategy relates risk to reward and clearly defines the exact cost of a losing trade and the gain of a winning trade. Proper money management reduces the anxiety surrounding the currency transfer involved in a given trade and puts the financial impact in perspective.
Goal setting is instrumental to fostering a positive, confident mental attitude in addition to providing a measuring stick for trader development. A rule-driven trading plan eliminates euphoria, as the rules govern all interactions with the marketplace, including both profitable and losing trades. Through the implementation of a comprehensive money-management strategy, anxieties related to capital loss are greatly reduced.
Attention given to these three areas can successfully mitigate many of the problems associated with emotional trading and minimise the negative impacts of fear and greed.
In order to successfully avoid the many pitfalls presented by active trading, ample time and effort must be given to the honest assessment of one’s emotional, and psychological state of being. Achieving a state of mind that fosters successful trading is a full-time endeavour and a discipline all of its own. The development of a comprehensive trading plan and the ability to execute that plan without any hesitation or bias is a key aspect of trying to achieve long-term profitability.
Trading on margin carries a high level of risk and losses can exceed deposited funds.
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|1.||↑||Retrieved 28 June 2016 http://faculty.haas.berkeley.edu/odean/papers/returns/Individual_Investor_Performance_Final.pdf|
|2, 3.||↑||Retrieved 28 June 2016 https://faculty.haas.berkeley.edu/odean/papers/Day%20Traders/Day%20Trading%20and%20Learning%20110217.pdf|
|4.||↑||Retrieved 28 June 2016 http://www.nber.org/papers/w11243.pdf|