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The Importance of Trading Psychology
Containing emotion and exercising discipline are key to making money
There are many skills required for traders to be successful in the financial markets—the ability to understand a company’s fundamentals and the ability to determine the direction of a stock’s trend are two of them. But neither of these technical skills are as important as a trader’s mindset: the ability to contain emotion, think quickly, and exercise discipline—what we might call trading psychology.
The psychological aspect of trading is extremely important. Traders often have to think fast and make quick decisions, darting in and out of stocks on short notice. To accomplish this, they need a certain presence of mind. They also, by extension, need discipline, so they will stick with previously established trading plans and know when to book profits and losses. Emotions simply can’t get in the way.
- Market psychology refers to the prevailing sentiment of financial market participants at any one point in time.
- Investor sentiment can and frequently drives market performance in directions at odds with fundamentals.
- Understanding what motivates fear and greed can give you the discipline and objectivity needed to be a successful trader and take advantage of others’ emotions.
When traders get bad news about a certain stock or the general market, it’s not uncommon to get scared. They may overreact and feel compelled to liquidate their holdings and go to cash or to refrain from taking any risks. If they do that, they may avoid certain losses, but they also may miss out on gains.
Traders need to understand what fear is: a natural reaction to what they perceive as a threat—in this case, to their profit or money-making potential. Quantifying the fear might help, and traders should consider pondering what they are afraid of, and why they are afraid of it.
By pondering this issue ahead of time and knowing how they may instinctively react to or perceive certain things, a trader can hope to isolate and identify those feelings during a trading session, and then try to focus on moving past the emotional response. Of course, this is not easy and may take practice, but it’s necessary to the health of an investor’s portfolio.
There’s an old saying on Wall Street that “pigs get slaughtered.” This adage refers to greedy investors hanging on to winning positions too long, trying to get every last tick. Greed can be devastating to returns because a trader always runs the risk of getting whipsawed or blown out of a position.
Greed is not easy to overcome. It’s often based on an instinct to try to do better, to try to get just a little more. A trader should learn to recognize this instinct and develop a trading plan based upon rational business decisions, not emotional whims or potentially harmful instincts.
To get their heads in the right place before they feel the psychological crunch, traders need to create rules. They should lay out guidelines based on their risk-reward tolerance for when they will enter a trade and exit it—whether through a profit target or stop loss—to take emotion out of the equation. Additionally, a trader might decide that in the wake of certain developments, such as specific positive or negative earnings or macroeconomic news, he or she will buy or sell a security.
Traders would also be wise to consider setting limits on the amount they are willing to win or lose in a day. If the profit target is hit, they take the money and run, and if losing trades hit a predetermined limit, they fold up their tent and go home, preventing further losses and living to trade another day.
Doing Research and Review
Traders should learn as much as they can about their area of interest, educating themselves and, if possible, going to trading seminars and attending sell-side conferences. Also, it makes sense to plan out and devote as much time as possible to the research process. That means studying charts, speaking with management (if applicable), reading trade journals, or doing other background work (such as macroeconomic analysis or industry analysis) so as to be up to speed when the trading session starts. Knowledge can help a trader overcome fear, so it’s a handy tool.
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In addition, it’s important traders remain flexible and consider experimenting with new instruments from time to time. For example, they may consider using options to mitigate risk, or setting stop losses at different places. One of the best ways a trader can learn is by experimenting (within reason). This experience may also help reduce emotional influences.
Finally, traders should periodically assess their performance. In addition to reviewing their returns and individual positions, traders should reflect on how they prepared for a trading session, how up to date they are on the markets, and how they’re progressing in terms of ongoing education, among other things. This periodic assessment can help a trader correct mistakes and change bad habits, which may help enhance their overall returns.
The Bottom Line
While it’s important for a trader to be able to read a balance sheet or a chart, there is a psychological component to trading that shouldn’t be overlooked. Being aware of how fear and greed can impact trading, exercising discipline, developing trading rules, experimenting, and periodically self-reviewing are crucial to a trader’s success.
Mastering Trading Psychology and Money Management to Trade Effectively
Is gambling an addiction? If so, why?
Especially in casinos, you will find people stuck to slot machines pulling the lever compulsively.
According to predictive analytics, even if some of those people end up winning the jackpot, they would prefer spending all that money back into the slot machine. Isn’t it quite interesting?
Some studies show that many slot machine addicts wear adult diapers because they don’t want to get up even to answer the nature’s call. Fingers crossed.
These machines were designed to exploit the variable reinforcement, which is inherent in human behavior. You may Google later.
Any response or action is called reinforced response if it generates a reward i.e., a person will be motivated to repeat a response if he or she gets a reward for the same.
Humans crave predictability and struggle to find patterns, even in its absence.
Variability is the brain’s cognitive nemesis and our minds make a deduction of cause and effect a priority over other functions like self-control and moderation.
Variable rewards induce addiction, it keeps our brains occupied.
Let me speculate a bit…
According to Professor Sanjay Bakshi, short-term speculators are like butterflies jumping from one flower to the next because of the presence of a pleasure chemical called dopamine in our brains.
The degree of pleasure is directly proportional to the amount of dopamine released.
Novel experiences like bungee jumping or a one night stand deliver enormous amounts of dopamine to the brain. Another thing which delivers dopamine is unexpected, pleasant surprises.
Day traders get a lot of small amount throughout the whole day.
To your surprise, I want to tell you that a doctor will not be able to distinguish the MRI of brains of a trader who just had a winning trade and a cocaine addict.
You are free to do the experiment.
As today is the first day of the remainder of our lives, so you and I, being a participant of the stock market, should take it seriously.
Thus, predicting that you will continue to read this article, I decide to proceed.
I dug into the matter and found out that it really makes us blind. It persuades us and pushes us into the rat race, i.e. a vicious circle of two emotions “greed” and “fear”.
There is an old saying on Wall Street that the market is driven by just two emotions which are greed and fear.
These two intrinsic emotional states relate the word “uncertainty” to the stock market.
Succumbing to these emotions can have an “utter and deleterious effect” on investors’ portfolios and the stock market.
It’s always better not to advertise our ignorance. So, being a common man, I want to share some common “Gyan”.
It is an inherent nature of human being to crave for more once he or she gets something.
Please don’t feel alone as a victim, I am with you.
It generates chemical rush through our brains and makes us bias by blocking our logical faculty in the brain. We get addicted to it.
It is normally characterized as an inconvenient, stressful situation etc.
One of the most common examples that I can think of now is “Dot-com bubble”, many refer it as “Internet bubble”.
It was created around internet start-up companies, which motivated investors to invest in businesses which had a “dot com” tag.
They became greedy which in turn created further greed which resulted in an overpriced situation, giving birth to a bubble.
For better understanding let me quote Investopedia’s definition of a bubble:
“A bubble is an economic cycle characterized by a rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive selloff occurs, causing the bubble to deflate.”
Please don’t get scared, I can understand that “Fear” is dominating your conscious mind. After the bubble crash, investors swiftly moved out and concentrated on less uncertain purchases.
Believe me, the superfluity of information will drown your head in massive noise if you search Google about the role of greed and fear in the financial world.
To avoid this complexity we can simply create a toolbox named “Risk management”. Though it is beyond the scope of this article to explain you this whole concept. A whole course can be developed based on it.
How to Manage Trade effectively
As this article focuses on money management, my target is to create a basic understanding of it
It is an integral part of risk management.
A trader will not be able to survive for long without it.
It deals with the question of survival. It increases the odds that the trader will survive to reach the long run. Many potentially successful systems or trading approaches have led to disaster because the trader applying the strategy lacked a method of controlling risk.
It is better to stay on the shore instead of getting drowned in the vast ocean. Hope you agree. Thanks for nodding your head.
A carpenter’s toolbox may make or break furniture. Likewise, a money management can make or break a trade.
Assuming you to be familiar with the term portfolio management. If not, no problem. Go on reading…
What is ‘Portfolio Management’?
According to Investopedia “Portfolio management is the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Portfolio management is all about determining strengths, weaknesses, opportunities, and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other trade-offs encountered in the attempt to maximize return at a given appetite for risk.”
You don’t have to be a mathematician or understand portfolio theory to manage risk. Hence, keeping aside all complexities we will approach it here on a relatively simple level.
Please take a deep breath and go through it…
According to Larry Hite, a famous hedge fund manager, we should-
- Never bet our lifestyle – never risk a large chunk of your capital on a single trade, and
- Always know what the worst possible outcome is
Let me share some general money management guidelines by John J Murphy. These guidelines refer primarily to futures trading–
- Total invested funds should be limited to 50% of total capital
- Total commitment in any one market should be limited to 10-15% of total equity
- The total amount risk in any one market should be limited to 5% of total equity
- The total margin in any market group should be limited to 20-25% of total equity
Have you heard of 2% rule? It suggests that never risk more than 2% of your capital on any one stock.
Breakdown of 2 percent rule –
- At first focus on your capital at risk, i.e. 2 % of your trading capital
- To get the maximum permissible risk you should deduct the cost on your buy and sell i.e. brokerage
- Now do a little maths to calculate risk per share. To do this- Step 1) In case of long, you should subtract your stop loss from the buy price and keep a provision for slippage Step 2) In case of short, you should reverse the process, i.e. subtract the buy price from the stop loss before adding slippage
- To arrive at the maximum number of shares, divide the maximum permissible risk by the risk per share
There is a famous maxim, “More the sweat in training, less the blood in war.” Likewise, you should always “Plan your trade and then trade your plan.”
Trying to win in the markets without a trading plan is like trying to build a house without blueprints – costly (and avoidable) mistakes are virtually inevitable.
A trading plan simply requires combining a personal trading method with specific money management and trade entry rules.
Krausz considers the absence of a trading plan as the root of all principal difficulties traders encounter in the markets.
Driehaus stresses that a trading plan should reflect a personal core philosophy.
He explains that without a core philosophy, you are not going to be able to hold on to your positions or stick with your trading plan during really difficult times.
If you want to know more about money management and trading psychology you can enroll for NSE Academy Certified Technical Analysis.
Maximum gains, not the number of wins
Eckhardt explains that human nature does not operate to maximize gain but rather the chance of a gain. The problem with this is that it implies a lack of focus on the magnitudes of gains (and losses) – a flaw that leads to non-optimal performance results.
Pull out Partial profits
Pull a portion of winnings out of the market to prevent trading discipline from deteriorating into complacency. It is far too easy to rationalize overtrading ad procrastination in liquidating losing trades by saying, “Its only profits.” Profits withdrawn from an account are much more likely to be viewed as real money.
Minervini believes that one of the common mistakes made by novices is that they “spend too much time trying to discover great entry strategies and not enough time on money management”. Strictly follow the below mentioned steps –
- Stop-loss points
- Reducing the position
- Selecting low-risk positions
- Limiting the initial position size
- Short selling
- Hedged strategies
Always remember that “you must be willing to accept a certain level of risk, or else you will never pull the trigger”.
It is most often used as a measure for trading individual stocks.
The optimal ratio differs widely among trading strategies.
Normally, some trial and error are usually required to determine which ratio is best for a given trading strategy.
Empirical study suggests that market strategists consider 1:3 to be the ideal risk/reward ratio
Traders can manage it directly through the use of stop-loss orders and derivatives.
I know you are very serious with each and every single trade of yours, hence, in a simple way, I will provide you some screenshots on how to maintain your portfolio in excel.
According to one statistics, only 10 % of the people read past the first two paragraphs of this article.
So, if you have read this far, I can say you are already ahead in the game.
Not the game of who knows more, but the game where knowing few essential ideas go a long way in reducing errors and increasing the quality of your trade.
After all, ideas are the currencies of the twenty-first century.
Some people lose money because they feel they don’t deserve to win, but more people lose because they never perform the basic tasks necessary to become a winning trader.
Questions must be crisscrossing your conscious mind…
I don’t want to waste your time, hence, just a synopsis
- Develop a competent analytical methodology
- Extract a reasonable trading plan from this methodology
- Formulate rules for this plan that incorporate money management techniques
- Back-test the plan over a sufficiently long period
- Exercise self-management so that you adhere to the plan. The best plan in the world cannot work if you don’t act on it
Let me quote Aristotle, “For the things we have to learn before we can do them, we learn by doing them.”
Believe me, to digest the concept you need not require an IQ Level of more than 130 (as 95% of population scores between 70 and 130).
Okay. Peace. I will explain.
He meant that we need to practice what we have learned in various situations.
These ideas and strategies do no good sitting inside our head like artifacts in a museum, for they need to be taken out and played with.
Some of the concepts mentioned here are the results of my speculation based on an article published by Safal Niveshak and books of Jack D. Schwager .
There is a non-zero possibility that the above strategies and conclusions are flawed. Hence, instead of taking them at face value, please consider them as starting points to stimulate your own independent thought process.
I sincerely thank you for going through this article. Feel free to post your suggestions and questions in the comment box below.
Trading psychology and money management
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What is Trading Psychology?
Trading psychology refers to the emotions and mental state that help to dictate success or failure in trading securities. Trading psychology represents various aspects of an individual’s character and behaviors that influence their trading actions. Trading psychology can be as important as other attributes such as knowledge, experience and skill in determining trading success.
Discipline and risk-taking are two of the most critical aspects of trading psychology, since a trader’s implementation of these aspects is critical to the success of his or her trading plan. While fear and greed are the two most commonly known emotions associated with trading psychology, other emotions that drive trading behavior are hope and regret.
- Trading psychology is the emotional component of investor’s decision making process which may help explain why some decisions appear more rational than others.
- Trading psychology is characterized primarily as the influence of both greed and fear.
- Greed drives decisions that appear to accept too much risk.
- Fear drives decisions that appear to avoid risk and generate too little return.
Understanding Trading Psychology
Trading psychology can be associated with a few specific emotions and behaviors that are often catalysts for market trading. Conventional characterizations of emotionally-driven behavior in markets ascribe most emotional trading to either greed or fear.
Greed can be thought of as an excessive desire for wealth, so excessive that it clouds rationality and judgement at times. Thus this characterization of greed-inspired investor or trading assumes that this emotion often leads traders towards a variety of behaviors. This may include making high-risk trades, buying shares of an untested company or technology just because it is going up in price rapidly, or buying shares without researching the underlying investment.
Additionally, greed may inspire investors to stay in profitable trades longer than is advisable in an effort to squeeze out extra profits from it, or to take on large speculative positions. Greed is most apparent in the final phase of bull markets, when speculation runs rampant and investors throw caution to the wind.
Conversely, fear causes traders to close out positions prematurely or to refrain from taking on risk because of concern about large losses. Fear is palpable during bear markets, and it is a potent emotion that can cause traders and investors to act irrationally in their haste to exit the market. Fear often morphs into panic, which generally causes significant selloffs in the market from panic selling.
Regret may cause a trader to get into a trade after initially missing out on it because the stock moved too fast. This is a violation of trading discipline and often results in direct losses from security prices that are falling from peak highs.
Trading psychology is often important for technical analysts relying on charting techniques to drive their trade decisions. Security charting can provide a broad array of insights on a security’s movement. While technical analysis and charting techniques can be helpful in spotting trends for buying and selling opportunities, it requires an understanding and intuition for market movements which is derived from an investor’s trading psychology.
There are numerous instances in technical charting where a trader must rely not only on the chart’s insight but also their own knowledge of the security that they’re following and their intuition for how broader factors are affecting the market. Traders with a keen attention to comprehensive security price influences, discipline and confidence show a balanced trading psychology that typically contributes to profitable success.
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