The Ultimate Guide to Trading Psychology
Trading Psychology is a term used to describe the emotional components of the trading world. Because markets are controlled by humans, there will always be a “human element” of trading that needs to be accounted for. In fact, it is largely because of trading psychology that markets move in unpredictable ways.
Trading psychology—which applies to both individual traders and “the herd” as a whole—can exaggerate price trends and misdirect traders away from potentially profitable possessions. Due to the forces of trading psychology and herd-like momentum, price trends will often overshoot what the underlying asset is “actually” worth.
One example where the impact of trading psychology is especially apparent is Bitcoin. Over the course of 2017, Bitcoin increased in value from around $900 to over $19,000. By the end of the next year (2018), Bitcoin would experience a sharp decline and drop in value to around $3,000. While there are obviously many reasons why these price trends played out the way they did, there is no doubt that trading psychology was a major factor.
In the Bitcoin example (which can also be seen among many other cryptocurrencies), traders opened positions as soon as the market “seemed” hot and closed positions as soon as the market “seemed” cold. Both technical and fundamental indicators at the time suggested these price swings were far beyond what was “natural”—however, the psychological forces of the many traders in the industry would ultimately prevail.
Trading psychology can typically be broken down into two emotional states: greed and fear. Greed causes traders to hold positions for longer than they should and fear causes traders to exit positions far earlier than can be justified on paper. If you hope to become a successful trader, both of these emotional states will need to be openly acknowledged.
Protecting yourself from Greed
Despite Wall Street’s (film) Gordon Gekko’s famous saying, “Greed is good”, there is no doubt that greed is something that needs to be actively managed. Greed may be good in the sense that it ought to drive you to strive for maximum returns on your investment. However, greed can also blind traders from seeing when their positions need to be closed out—greedy traders may take on disproportionate levels or risk and miss on out possible profit points.
Fortunately, there are many things traders can do to protect themselves from the risks of greed. The first thing you should do, when trading in any speculative market, is to determine stop order levels before you’ve opened a position. By identifying acceptable exit points in advance, you can protect yourself from chasing profits that are incredibly unlikely to materialize. You’ll still be able to profit from your positions, yet, risk will be effectively managed.
Another way to protect yourself from greed is to choose a few reliable technical indicators. If holding a position cannot be justified on paper, then you should probably let the position go. Technical indicators—such as the relative strength index, Bollinger Bands, and various moving averages—will make it much easier to see if your hopes are supported by reality.
When compared to greed, fear is a much more difficult component of trading psychology to manage. One of the most forms of fear is the fear of missing out (FOMO). After traders have seen a stock or speculative asset skyrocket in price, they may be tempted to open a similar position of their own. However, by the time this trend has been noticed, it may already be too late. If technical indicators do not support the trend continuing, these positions will need to be avoided.
On the other hand, once a position begins to lose money, you may be tempted to exit early and cut your losses. However, while this may sometimes be necessary, excessive amounts of fear can cause you to exit when prices are at their absolute lowest points. Using stop losses and various technical indicators (particularly channel indicators) will once again be helpful. It will also be important to recognize that instead of trying to win every position you open, you’ll be much better off striving to win as many positions as you can. When all else is equal, two losses and ten wins will be much more profitable than five wins alone.
Outsmarting “The Herd”
Generally speaking, traders as a collective tend to be quite dramatic. In bullish markets, prices will tend to shoot far beyond their natural levels and in bearish markets prices will shoot far below these levels. Opening positions towards the edges of trading channels can help you enjoy a low-risk return back to the expected norm.
In order to exploit the weaknesses exposed by trading psychology, you may want to develop a contrarian trading strategy. Contrarian trading is especially useful when certain news stories begin to break. If a negative news story—such as an accident or a scandal—emerges, many investors holding long positions in the corresponding company will decide to “jump ship.” However, this decision to leave is rarely justified by actual changes in the company’s value. Following the price drop, contrarian traders will enter into a long position and, after a few days, prices will likely increase.
In order to become a successful trader, you will need to account for as many trading variables as you feasibly can. Trading psychology is a variable that many traders tend to overlook. As long as you can address greed, fear, and the often misdirected will of the herd, you can maximize your potential for returns while minimizing your exposure to risk.