Introduction to Trading Psychology

What’s the biggest difference between a test match and a T20? The same player can’t play them with the same mindset. Similarly, in stock markets, you need to follow completely different approaches to trading—which is more like a T20 match—and investing—a test match equivalent.

The success of a trader often depends on the confluence of three factors—trading strategy, trading tools and trading psychology. Nowadays, many investors have an easy access to readymade trading tools and trading strategies—thanks to path-breaking technological advancements. Therefore, trading psychology often becomes a deciding factor between a successful trader and an ordinary trader.

What is trading psychology?

Trading psychology pertains to the decision-making process of a trader that affects the trading outcomes, i.e. profits or losses. Mastering trading psychology helps improve your trading outcomes by dealing effectively with your emotions.  

On the other hand, the psychology of stock market reflects the collective behaviour of all market participants based on their individual cognitive responses to trading activities.  

Psychological factors that may affect your trading performance

Greed: When traders become greedy, they focus only on favourable outcomes i.e. profits and completely disregard the possibility of incurring losses. Moreover, when traders throw caution to the wind, they also pay little attention to their position size, which can be catastrophic for their trading performance. 

For instance, a trader who fails to see any downside to his trade may increase his position size 5X from Rs 1 lakh per trade to Rs 5 lakh. If his trading bet goes against him, it can prove catastrophic at times. 

Fear: If greed can make a trader overtrade, fear can lead to his/her inaction and ignorance. When traders are too scared of losses, they might abstain from trading even when markets offer them attractive opportunities. Furthermore, if they are fearful of losses they might take their chances of holding out a position even when stoploss gets triggered. 

It’s noteworthy that greed and fear are the two most basic emotions that affect the trading or investment decisions of almost all market participants. 

Speaking about the psychology of stock market, when investors and traders in general are greedy, the result is ascending markets and expensive valuations. Whereas, when investors are fearful, broadly, markets slide and valuations become depressed.  

Greed and fear often produce undesirable results in the form of regret, frustration, doubt and excitement, to name a few. 

Biases: Trading bias refers to a situation in which a trader takes trading decisions based on certain preconceived notions without paying attention to data and changing market conditions. This often results in trading losses or loss of opportunities, depending on the nature of the bias. Some widely found trading biases include, confirmation bias, anchoring bias, overconfidence, loss-aversion bias and status quo among others.

Tips for improving trading psychology     

Don’t forget the 80/20 Rule 

Pareto’s principle, like in most other walks of life, holds true even in trading.  It’s been observed that 80% of trading profits come from 20% of trades.  Therefore, it’s crucial to have realistic expectations. Many naïve traders expect the majority of their trades to fetch them profits. However, what really matters is how much money you make on profit-making trades. 

Take a personality test

It may sound slightly awkward, but taking a personality test before you dabble into trading can help you immensely. Taking a personality test will offer you a better understanding of your natural inclinations and in turn help you deal with your cognitive biases effectively. Based on your personality, you may then build your own trading strategies. 

Walk-away after punching trades 

Yes, you read it right. If you are continuously glued to screens after punching your trades, the real-time ups and downs can be quite unnerving and may compel you to take uninformed decisions based on external psychological stimuli. 

Moreover, it’s better not to start a day with charts; instead, a trader must carry on with the routine and should be in a positive frame of mind before punching trades. 

Start writing your trading diary  

Maintaining a trading journal can help analyse what works for you and what doesn’t. Ideally, a trader should write a trading rationale in brief for each trade besides entry and exit points and profit and loss figures. This practice not only can help take well-informed decisions but also minimise losses on account of repeated mistakes. 

Stick to your rules 

It’s imperative to be a disciplined trader if one aspires to be a successful trader. 

You should apply a stoploss to every trade and more importantly stick to it without making any exceptions. Similarly, you should also have well-documented rules for exiting your trading positions. 

Conclusion

Since emotions interfere with trading decisions and affect the performance of a trader, managing stress and following a disciplined approach is the way out. And please don’t forget that since Pareto’s principle works in trading, the majority of traders don’t make money in trading. Therefore, it’s all the more important to ensure that you have the right temperament and trading mindset.