6. Trading Psychology

Trading isn’t for the weak at heart, it’s a lot more emotional than you may think, and before you can master trading you have to learn to master your emotions.

Trading psychology – what does it mean and why is it important?

Trading psychology is about understanding the way we react mentally to the stresses and pressures of trading
Controlling your emotions is essential to successful trading, without a clear mind you won’t be able to make rational trading decisions.

The Emotions of Trading

When trading there are two emotions that are more common, and more dangerous, than all the rest; fear and greed.

Fear and greed can ruin even the best trading strategies

One moment of fear or greed can lead to a moment of madness and months of hard won profits going down the drain

Uncontrolled emotions should not be an excuse for losses and losses should not be an excuse for uncontrolled emotions

Remember!! Trading affects psychology as much as psychology affects trading

Greed

“You can’t feed on greed”

  • Many people think that greed is thinking that the sole aim of trading is to make money.
  • This is NOT what greed is

Greed is trying to make money too quickly
There are lots of ways to be greedy in trading;

  • Trading in sizes that are too large
  • Trading too frequently
  • Having unrealistic expectations
  • Dreaming of the big hit trade, rather than steadily building your equity

Fear

Fear in trading has two faces;

  • Fear of loss
  • Fear of missing out

The fear of loss compels traders to close profitable trades prematurely, meaning they miss out on potential profit
The fear of missing out compels traders to abandon their trading strategy so they do not miss a major price move
Fear is NOT good as it leads to overtrading and miss-timed entry and exit points
So
DON’T BE SCARED!!

Managing Risk and Emotion

Risk management involves calculating how much risk you are prepared to tolerate in order to make a profit

For a more detailed look at Risk and Risk Management tools please refer back to the "Risk" Module

When trading it is important that traders realise the importance of Risk Management; it teaches you to pace yourself, to think clearly, and most of all, it helps keep your emotions under control.

Here are a few things you should think about when trading

Trade size - Start with small trades

When you take a hot bath, you don’t just jump in straight away; you test the water temperature with your toes first. Trading is no different. Never jump into the market with your entire position. Test the market first with a smaller trade before taking your full position

  • Trade sizes that are too large for your account can cause exaggerated price swings and play havoc with your account as well as your emotions. This can then lead to mistakes caused by fear or greed. Like we said before trading affects psychology as much as psychology affects trading
  • Do not forget that a trade can go wrong – if you are dreaming of a huge profit by taking a large trade size, remember this high risk trade can also produce a loss as big as the profit you were dreaming of.

Risk/reward ratio

Aim for at least a 3-1 or at worst a 2-1 Profit/Loss ratio

  • For example, if you are aiming for 60 pips profit, your maximum loss should be around 30 pips. Or, if the maximum loss you are prepared to take is $1000, your profit target should be at least $2000
  • If your trading style is to get in and out of the market for a small profit each time then make sure your losses are also small.

Planning your risk/reward ratio means that you can prepare yourself mentally for the loss that you might face and prevent emotional trades.

One wrong emotional trade can produce a large enough loss to wipe out the profit of many profitable trades

P/L targets

  • You should have exit points in mind before you make a trade
  • You should daily have P/L targets

Once you reach this target you should stop trading so as to avoid giving profits back to the market

P/L targets help to avoid fear and greed compelling you to overtrade and/or increase your trade size

Market volatility

Some times of day are more volatile than others:

Afternoon in London, which corresponds to morning in New York, is the most volatile time of day for most markets, with the largest price swings and profit potential and losses.

During periods of extreme volatility it is usually best to stand aside if you are not an experienced trader.

Trading tips

Here are some more trading tips that you may find useful

Implement risk management

Use stop losses and limits – these take the emotion out of closing a trade and reduce the risk of unnecessary losses as a result of attachment to a position.

Traders allow losses to grow as their emotional attachment makes them hope the price will reverse

  • The hardest thing a trader has to do is manually close a losing trade; placing a stop loss order at the same time you make a trade will avoid having to do this.
  • Traders often complain when their stops hit then the price reverses; never cancel a stop loss order after you have placed it. You placed the stop when you were calm before you entered the trade; now you are stressed because the trade is moving against you

Trust your original judgment!

Treat trading as a business not a hobby

You wouldn’t invest $10,000 in a business enterprise on impulse – so don’t do it when trading!

Make sure to make time for researching the markets when you are not trading

An informed trade is always a better option than an impulsive trade

Patience

Patience is a virtue in trading; it is different to not trade through fear
Patience means…

  • …waiting for the price to hit your indicators before trading
  • …waiting hours if necessary for the correct time to enter the market. Trading profitably is what matters, not the number of trades per day
  • …not jumping in and trading just because you see the price moving or you are bored
  • …not trading on a tip. You will find wildly divergent opinions even among so-called experts. Do your own research before you trade

Standing aside is a valid trading decision

Overtrading

  • Overtrading is a common mistake made by new traders as they try and catch every small price move
  • The price moves down so they sell, it moves up so they buy, in doing so they are always chasing the market and usually losing.

Learn to anticipate price moves, not just follow them

Time frames

  • Short term trading is highly intensive and requires lots of discipline and concentration so make sure you are ready for this level of intensity and can trade without distractions
  • Longer term trades do not have to be monitored constantly and are more appropriate for traders with other commitments

Coping with losing trades

Learn to love your losses

This is a term heard often in the trading world, and if you don’t learn to embrace your losses, your trading career will probably be short lived.

So, what exactly does “learn to love your losses” mean?

It means you should understand why you made a losing trade;

  • Did you misread your indicators?
  • Did you fail to anticipate the release of an important piece of economic data?

Some losing trades are not your fault; for example, an unpredictable event such as a terrorist attack could move the market, but…

The majority of losing trades are because the trader made an impulsive decision

  • To lessen the psychological impact of a loss, redefine a loss from being a failure, to being an opportunity to learn
  • Do not blame the markets for your losses, the markets don’t owe you anything - look at your strategy and adjust accordingly

Trade based on what the market is doing rather than what you think it should be doing. Trends and market conditions can change; make sure your strategy changes with it.

Taking profit

Cut your losers and run your winners

  • Don’t take profits too early through fear. Fear causes the mind to question and react while the trade is still “safe” and in profit, no matter how small.
  • Conversely, don’t let a winning trade turn into a loser
    Set yourself rules to follow; close a trade if the market retraces 20% from your profit target. This allows you to make sure that your emotions don't get out of hand when trading
  • Except in special circumstances, get in the habit of taking your profit “too soon”
  • Don't torment yourself if a trade continues not to move in your favour.  A common mistake is to close a position that is in profit and keep one that shows a loss.

Building your account equity

Don’t try to make your fortune in a single trade – you will never be satisfied if you have unrealistic expectations

  • Aim to build your account steadily
    5% per day is a great return
  • Remember you will have periods of equity draw downs or sideways movement
    If you have 3 losing days in a row, take a step back from trading for at least a day to collect yourself.
    Use this time to reassess your strategy and analyse the market

To summarise, don’t underestimate the power of your emotions…

TAKE CONTROL OF YOUR TRADING, DON'T LET TRADING TAKE CONTROL OF YOU

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