The Psychology of Trading

When trading, the two most common and dangerous emotions are fear and greed.

Fear and greed can ruin even the best trading strategies. A single moment of fear or greed and lose your months of hard-earned profits.

Having discipline and keeping your emotions under control is an invaluable skill in trading.

Greed is trying to much make money too quickly when trading. This happens when you take on a position that is too large or trade at a high frequency beyond that of a feasible trading strategy. Rather than dreaming of making a unrealistically large, one-time winning trade, it is better to steadily build equity.

Meanwhile, fear in trading has two faces: the fear of loss, and the fear of missing out. The former compels traders to close profitable trades prematurely, meaning they miss out on potential profit. The latter compels traders to abandon their trading strategy so they do not miss a major price move.

While caution is a good thing when trading, fear leads to overtrading and miss-timed entry and exit points.

Overcoming fear and greed can be done with careful risk management by calculating how much risk you are prepared to tolerate when trying to make a profit. To successfully overcome fear and greed, you need to have discipline and stick to the principles and rules that govern your trading strategy. Here are some of the most important ones:

Start with small positions

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. 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 also risks a loss as big as the profit you seek.

Figure out a profitable risk/reward and win/loss ratio

Aim for at least a 3:1, and at worst, a 2:1 profit-reward ratio. This means entering into trades with a strategy where you make at least twice your potential loss. For example, if you are aiming for 60 pips of 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.

However, this also needs to take into account your win/loss ratio. This is the average chance that your strategy has of making a profitable trade. If your strategy has a 2:1 profit-reward ratio, and a 1:2 win-loss ratio (which means you win 50% of all trades), you are just breaking even on your trades.

Planning your risk/reward ratio means that you can prepare yourself mentally for the loss that you might face and prevent emotional trades as one wrong emotional trade can produce a large enough loss to wipe out the profit of many profitable trades

Have clear profit/loss targets

Before you begin on a trade,  you should have exit points in mind for both taking profits, and minimising losses. This doesn’t just apply to individual positions. Have daily profit and loss targets,  and stop trading once you hit those targets. This helps build the discipline to avoid fear and greed compelling you to overtrade and/or increase your trade size.

Know the market

Some times of day are more volatile than others. For example: afternoons 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. Other volatile periods include right before, and after the release of important economic data like the US Nonfarm Payrolls.

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

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.

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.

Never cancel a stop loss order after you have placed it. The stop was placed when you were calm, and changing it because you are stressed in an unfavourable market can exacerbate losses.

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

Have patience

Like the saying goes: patience is a virtue. Patience means waiting for the prices to hit your indicators before executing your trades, and waiting hours if necessary for the correct time to enter the market. Trading profitably is what matters, not the number of trades per day.

Patience also means not trading on a tip. You will find wildly divergent opinions even among so-called experts. Do your own research before you trade. Doing nothing is a valid trading decision – sometimes, inaction is the best move you can make.

Avoid overtrading

Overtrading is a common mistake made by new traders as they try and catch every small price move. They sell when the price moves down, and buy when it moves up. In doing so they are always chasing the market and usually losing. Learn to anticipate price moves, not just follow them.

Look at 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 losses

“learn to love your losses” 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. Understand the reason for a losing trade. Maybe you misread the indicators, or failed to anticipate the release of an important piece of economic data.

Some losing trades are unavoidable due to unpredictable events like natural disasters, 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.

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 rules to follow: close a trade if the market retraces 20% (for example, with a trailing stop) 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”.

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. Instead, 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.

A mantra to live by is:

Take control of your trading, don’t let your trading take control of you