uTrade Algos
Many experienced traders say that the stiffest challenge you’ll face in becoming a trader is conquering your own psyche! Trading psychology refers to the emotions and state of mind, which contribute to success or failure in securities trading. It reflects different aspects of the character and behaviour of a person, which influence their trading acts. Trading psychology may be as critical in assessing trading performance as other qualities such as awareness, experience, and ability. Some of these emotions are helpful and should be embraced while others like fear, greed, nervousness and anxiety should be contained. The psychology of trading is complex and takes time to fully master. In reality, many traders experience the negative effects of trading psychology more than the positive aspects. Instances of this can appear in the form of closing losing trades prematurely, as the fear of loss gets too much, or simply doubling down on losing positions when the fear of realising a loss turns to greed. Read on to know more.
Table of Contents
What is Trading Psychology?
Trading psychology refers to the study of how a trader’s emotions and mental state can affect a trader’s trading decisions. Depending upon the share market and trader strategy, the trading psychology of each trader can differ.
The psychology of traders plays a vital role while placing a trade, setting a stop-loss or exiting a trade. To enhance their trading psychology, traders can develop a trading roadmap. This plan can carry out different steps depending on the present and upcoming events in the trade.
Basics of Trading Psychology
Managing Emotions
Fear, greed, excitement, overconfidence, and nervousness are all typical emotions experienced by traders at some point or another while trading. Managing the emotions of trading can prove to be the difference between growing your equity account or going bust.
Understanding FOMO (Fear of Missing Out)
Traders need to identify and suppress FOMO as soon as it arises. While this isn’t easy, traders should remember there will always be another trade and should only risk amounts that they can afford to lose.
Overcoming Greed
Greed is one of the most common emotions among traders and therefore, deserves special attention. When greed overpowers logic, traders tend to double down on losing trades or use excessive leverage in order to recover previous losses. While it is easier said than done, it is crucial for traders to understand how to control greed when trading.
Implementing Risk Management
The significance of effective risk management cannot be overstated. The psychological benefits of risk management are endless. Being able to define the target and stop loss, up front, allows traders to breathe a sigh of relief because they understand how much they are willing to risk in the pursuit of reaching the target.
Avoiding Trading Mistakes
While all traders make mistakes regardless of experience, understanding the logic behind these mistakes may limit the snowball effect of trading impediments.
Along with the previously mentioned mistakes, traders are attuned to committing another (big yet generally ignored) mistake and that is being biased. As per neuroscience, bias is a part of human nature, and unconsciously people are affected by it even during investing in the stock market. Let’s discuss this in detail.
Learning to Avoid Top Biases
Confirmation Bias
Confirmation bias is also known as confirmatory bias or the myside bias. It is the tendency of people to seek out information that supports something they already believe in. This type of bias affects our critical thinking, causing people to remember the hits and forget the misses—a common flaw in human reasoning.
People will often cue into things that matter to them (the things that support their own beliefs) and dismiss the things that don’t. This can lead to the ostrich effect, where a subject has overconfidence in their own opinions, and ‘buries their head in the sand’ to avoid contradictory evidence that may disprove their original point of view.
How Confirmation Bias Affect Traders
Let’s look at an example of confirmation bias:
I have four cards for you (each has a number on one side and a letter on the other side). One of the cards shows an E, one shows a 4 on one face, one has a K on one face, and one has a 7. I say that a card with a vowel on one side (such as ‘E’) must show an even number on the other side. My question to you is: Which card(s) do you need to turn over to see if I am telling the truth? Also, what’s the minimum number of cards you need to turn over in order to see if I am telling the truth? What did you choose? Most people will choose the E and the 4. Unfortunately, that’s not the correct answer. The correct answers are actually E and 7.
- If you turn over the E, and you find that there is an odd number, you’ve proven that I was lying.
- If you turn over the 7 and you find that there is a vowel, then again, I was lying.
- By turning over the 4, if there is a vowel on the other side, you only prove that you don’t prove anything. All you do is confirm my statement.
The truth is we are all prone to confirmation bias. We tend to look for confirming, rather than disconfirming, evidence. Most of us have a bad habit of only paying attention to information that agrees with our existing beliefs. We also tend to form our views first, and then spend the rest of the day looking for information that makes us look right. Our natural tendency is to listen to people who agree with us because it feels good, it feels all warm and fuzzy, to hear our opinions reflected back to us.
We choose the news that reflects our views and opinions. However, it is disastrous for investment decision-making. Instead, for a holistic analysis of the markets and our decisions, we should also be looking for disconfirming information and disconfirming evidence.
Avoiding Confirmation Bias
Biases influence all human decision-making, so it’s important to be aware of how these preconceived notions can influence our behaviour and choices. Here are a few tips on how to reduce confirmation bias:
- Allow yourself to be wrong: If you want to get closer to objective truths, you have to be able to admit you were wrong, especially in the face of new data. If you can’t admit defeat, it makes you incapable of discovering new avenues in the stock market.
- Test your hypothesis: We’re typically more aware of our assumptions than of our biases, but like biases, assumptions often keep us away from understanding the flip side. It’s risky to presume that your assumptions are correct. Always test your hypotheses. You can do this by searching out disconfirming evidence of your theories and forming factually-supported arguments with new evidence that can further prove your point. Paper trade your hypothesis before you invest your actual money.
- Beware of repetition: For emphasis, for intensity, for effect, things are repeated constantly. This tactic is actually a form of brainwashing wherein you begin to think that something is true simply because you’ve heard it so many times. Be aware of repetition and be especially sceptical of what powerful people tell you again and again and again.
Gambler’s Fallacy
Statistics is always surrounded by two kinds of events—dependent and independent events. New technology and data mining techniques are all about using past data in order to make predictions about the future. However, is this always true? Does the future data always depend upon its correlated past data? Even statisticians were not too sure of this. Gambler’s Fallacy is one such proof which states that a human mind often interprets the outcomes of a future event judging by its corresponding past events even if the two are completely independent of each other.
How Gambler’s Fallacy Affects Traders
Imagine a coin flipped ten times coming up every time with heads. What would you bet for the 11th flip? Do you think it’s more likely to land on tails? If you’re tempted to say yes, it may be a result of a gambler’s fallacy.
Gambler’s Fallacy is a common practice in the investing domain as well. Investors tend to liquidate their positions (or their bet) over something which is long overdue—again.
For example, if a stock is continuously making new highs for the last four consecutive days, few may think that it will correct on the fifth day, so it is better to leave the position. On the other hand, the rest might argue that it will continue to rise because of the momentum.
Avoiding Gambler’s Fallacy
Looking back to the coin toss example: after you’ve thrown tails on a coin three times, if you believe that the probability of heads is less than 50 per cent, you risk making irrational decisions. When trading, pay close attention to price rises and falls, and look at the overall trend—is it going up or down? Make your trading decisions based on logic, independent research, and basic technical analysis.
The Bandwagon Effect
The bandwagon effect is the tendency of people to take certain actions or arrive at a conclusion primarily because other people are doing so. The phenomenon is observed in various fields, such as economics, politics, and psychology. Financial markets are no different.
Bandwagon Effect on Financial Markets
Price Bubbles
Price bubbles often happen in financial markets wherein the price for a particularly popular security keeps on rising. The price can rise beyond a point that would be warranted by the fundamentals, causing the security to be highly overvalued. It happens because many investors line up to buy the security, bidding up the price, which in return attracts more investors.
Liquidity Holes
In case of unexpected news or events, market participants tend to halt trading activity until the situation becomes clear. It reduces the number of buyers and sellers in the market, causing liquidity to decrease significantly. The lack of liquidity distorts price discovery and causes massive shifts in asset prices. Such price shifts can lead to increased panic, which further increases uncertainty, and the cycle continues.
Avoiding the Bandwagon Effect
Considering how bad the effect is we have gathered a few ways to avoid it.
- Always cross-checking reliable sources of information on the Internet or with your broker.
- Checking the validity of any information is necessary. Asking the source or checking various sites helps us reach a credible conclusion.
- Trying not to jump to conclusions immediately. Jumping to conclusions is what allows the Bandwagon effect to be so effective. Try to stay neutral until enough evidence is provided.
- Being more open-minded to absorb new information and possibilities.
Conclusion
Trading psychology significantly impacts financial outcomes and overall market experiences. Recognise and address your weaknesses and biases before entering a position. Understand your strengths without being paralysed by conflicting thoughts. Learn from wins and losses, utilising online trading apps for accessible information. Assess each position independently, knowing when to take profits or cut losses. Maintain a trading log for self-reflection and use the insights to enhance decision-making. Apply this newfound awareness to Share India’s user-friendly tools and advanced technology by easily opening an account with a few clicks.