Maintaining the right mindset is an essential factor in being a successful trader. Learn how to improve your trading psychology and minimize the impact of emotions.
What is trading psychology?
The term trading psychology refers to a trader’s mentality when active in the market. This can be used to determine the extent to which he succeeds in securing a profit. At the same time, it can also explain why a trader has suffered heavy losses.
Intuitive human traits such as cognitive biases and emotions play an important role in trading psychology. The main focus of the trading psychology learning process is to become aware of the various pitfalls associated with having an adverse psychological trait and to develop more positive traits.
Traders well-versed in trading psychology generally do not trade based on cognitive biases or emotions. They have greater chances of making a profit in their market activities or at least of minimizing their losses.
Trading psychology differs from trader to trader as individuals are impacted by factors such as emotions and predetermined cognitive biases. Some emotions that can affect trading are:
How to improve your trading psychology
Learning about your emotions, cognitive biases, and personality traits is the easiest way to improve your trading psychology. Once you accept these, you can develop your own trading plan that considers these factors in hopes of reducing the impact of these traits on your decision-making.
For example, if you are inherently confident, you may find that overconfidence and pride affect your decision-making. For example, instead of taking a slight loss, you don’t intervene in losses in hopes of a market reversal. This can result in even higher losses or even ruin your trading account.
To counteract this, you can set stops before opening the position, minimizing losses and deciding when to close a particular trade. In doing so, you have faced your own cognitive distortions and emotions and consciously decided not to let them guide you. Instead, you have taken active steps against it.
How does cognitive bias affect trading?
Cognitive biases interfere with the trading process because, by definition, they are a predetermined personal bias for or against something. As a result, your decision-making in your market activities is compromised as your judgment is clouded, and you rely on gut feeling rather than sound fundamental or technical analysis.
The reason for this is to be found in the trading bias. That is, you’re more likely to trade an asset that you’ve traded successfully in the past or avoid an asset on which you’ve suffered a historic loss.
It is essential for a trader to know their own biases. This can help overcome them and lead to a more rational approach to the market and a more nuanced mindset.
There are five main types of cognitive biases
Representative bias means you are clinging to or trying to copy previously successful trades. They don’t even analyze the trades as they have a proven track record in the past. However, even with similar trades, it’s essential to approach each trade in terms of its own worth and not based on its past success
Negative bias leads to only looking at the negative side of a trade instead of the good side. This can mean that you have thrown an entire strategy overboard and really only needed to tweak a few tweaks to make a profit
The status quo bias suggests that instead of trying something new, you continue to use your old strategies or execute proven trades—you stay with the status quo. The danger comes from misjudging whether the best practices are still viable in the current market
With confirmation bias, you only look for or give weight to the news and analysis that confirm your pre-formulated ideas. It is also possible to avoid looking for information or ignore information that contradicts your beliefs.
In the gambler’s fallacy, you assume that an increasing asset value will continue to increase. But there is no reason for this assumption. Similar to how there’s no reason a coin would always land tails up instead of heads after you’ve successfully done this a few times in a row
Identify your personality traits
One of the most critical aspects of developing a successful trading psychology is that you determine your personality traits from the start. You have to be honest with yourself and admit to yourself, for example, that you tend to have impulsive tendencies or act out of anger and frustration.
If this is the case, then it is especially important for you to keep these personality traits under control when you are in the market. Because these qualities can lead to hasty or unwise decisions without an analytical background, you must play to your personal strengths. For example, if you have a relatively calm or calculating nature, you can definitely benefit from this personal trait in your market activities.
Recognizing the above personal biases is just as important as recognizing and knowing about your personality traits and emotions. Cognitive distortions are an innate aspect of human nature. Before opening or closing a trade, you should know your biases.
Develop a trading plan and stick to it
Developing a trading plan is critical to achieving your goals. A trading plan serves as a blueprint for your trading activity. In it, you establish your time commitment, available trading funds, risk-reward ratio, and a trading strategy you are familiar with.
For example, you can specify in a trading plan that you will trade for an hour each morning and evening and will only spend up to 2% of your total portfolio value on any trade. This practice can help minimize losses and limit the impact of emotions on your trading since you have already set the rules for opening or closing a position.
When creating a trading plan, you should consider individual factors such as emotions, personal biases, and personality traits that can affect your trading discipline. If you consider your personal biases before you start trading, you may let them guide you less.
Act patiently
Patience is an essential part of discipline. It is crucial that you remain patient with your positions. Trading on emotion can cause you to miss out on a profit by closing a position too early. Trust your analysis and stay patient and disciplined. It is also essential to be patient and wait for an opportune moment to enter a trade rather than jumping straight into it.
For example, if you want to speculate on some GBP currency pairs, such as EUR/GBP or GBP/USD, you might wait until just before an announcement from the Bank of England (BoE), as the effect of volatility is amplified at that time.
Be adaptable
While a trading plan is very important, remember that no two trading days are the same. And there are no winning streaks in stock trading, either. Keeping this in mind should make it easy for you to gauge and adapt to different moods in the market daily.
When the market is very volatile on a day compared to the previous day, and the market direction is unclear, it sometimes makes sense to put trading activity on hold until you understand what is happening in the markets.
Adaptability can also help rule out emotion and representational and status quo biases. This puts you in a position to assess each situation in terms of its merits. Another positive side effect of this skill is that it allows you to ensure a pragmatic approach when operating in the markets.
Give yourself a break after a loss
After suffering a loss, the best thing to do is let the trading account rest for a while, clear your mind, and calm down, rather than rushing into the next trade and trying to recoup the losses.
The best traders are those who take their losses and see them as learning opportunities. They usually take a few minutes before proceeding with trading. They use the time to analyze what went wrong in a particular trade and hope to avoid making that mistake in the future.
This way, they can control their emotions like pride or fear before moving on to the next trade. This cooling-off phase clears your head and ensures a reliable assessment.
Accept your winnings
Even after you’ve made a profit, taking a break is usually a good idea. Several or exceptionally high wins can quickly make you think you are invincible. The result: they fall into a different position and try to repeat your success.
You may even open several new positions believing that none of them will disappoint because today is “your day.” As a result, you take unnecessary risks and diversify your portfolio far too quickly without a fundamental analysis of the relevant markets.
So contentment can be just as dangerous to your market activity as anger. Therefore, it is vital that you recognize when your decision-making is being compromised or negatively impacting your trading psychology.
Keep a trading log
With a trading log, you record all losses and profits and the emotions experienced. Therefore, it is the culmination of all the points mentioned earlier in this article. It can be used to assess whether your decision was right at a specific time.
For example, you can record the point in time when you decided to cut your losses and the final price that the asset ultimately reached. With this, you can see whether you made the right decision. You can also use it to note when you took your profits and whether your decision to close the position early or late was driven by your emotions.
Trading psychology summarized
Trading psychology is all about the way you think when you are in the markets. This can be used to find explanations for your wins or losses
- Knowing your weaknesses and cognitive biases is essential before opening a position. At the same time, you have to know your strengths very well
- Learn from your wins and losses, but always remember: winning streaks do not exist in trading, and each position should be evaluated on its own merits
- Knowing when to take a profit and when to cut a loss makes the difference between a good day in the market and a bad day.
- Keep a trading log to review what worked well and what didn’t. If, in hindsight, your decision was the right one at a given point in time. Use this information to improve your decision-making in the future.