Trade The Journey

Trade The Journey

The Psychology of Trading: How Emotions Can Impact Your Decisions

Psychology is defined as the scientific study of the mind and behavior. In trading, psychology was often viewed as an inconsequential part of trading success but as time went on that changed. Authors like Mark Douglas and Paula Webb began to question the notion that psychology and trading were unrelated in the early eighties.

Books like “The Disciplined Trader” and “Trading in the Zone” opened the minds of many to the possibilities of becoming a successful trader using trading skills and psychology together. You can find lectures given by Mark Douglas detailing his methodology for transforming your mindset on YouTube.  Personally, I’ve watched the YouTube lecture series more times than I count.

In his books and lecture series, he speaks about the randomness of the market and the control that successful traders exhibit amid that randomness. As he states throughout his book and lecture series, successful traders typically have a large drawdown (Losing a lot of money) before they are able to develop the awareness and skill to trade in their zone.

Trading in the Zone as I understand is the ability to enter and exit the trade flawlessly, accepting random results without allowing the results to damper your enthusiasm for the next trade. Although this process is easy to understand, being able to maintain this state of mind can take time to develop. Finding your zone amid randomness and unpredictability is at the root of trading psychology.

The most important aspect of trading psychology is knowing who you are. Socrates is credited with the aphorism, “Know Thyself”. Knowing yourself means understanding your strengths and weaknesses, tendencies, and abilities. To find out who you are requires a bit of work and self-discovery, which isn’t a task that most find necessary or needed but a trader must engage in this type of work to discover their abilities and predispositions.

For example, I am prone to impatience and impulsiveness which has resulted in ill-advised trades and large losses. I also know that I am a big-picture thinker and often miss minor details if I am in a rush to complete a project or trade. While big-picture thinking may assist me in foreseeing trends, details are a major part of trading successfully.

Knowing this about myself, I set rules to help remedy some of my natural tendencies like completing my homework the night before placing a trade to prevent me from placing an impulsive ill-advised trade. I also write down all the details of the trade while completing my homework which forces me to slow down and think deeply about the trade I am about to place.

One quote I particularly remember from the Mark Douglas lecture series is that “Trading can be one of the best vehicles for self-development that there is.” The reason why this is so is that we trade what we believe about the market. What we believe will be a direct representation of how we approach the world.

What does it mean to be wrong?

For a long time, I interpreted being wrong about a trade as a statement of who I was as a person. I associated each losing trade as a form of evidence that I lacked sound decision-making skills. Each losing trade was an addition to a long list of things in which I failed to succeed in. When in reality, the trade could have resulted in a loss for a number of reasons. Perhaps a large trader decided to liquidate his holdings to because they needed the cash or an event that was unknown to the market was discovered by an insider causing them to sell. There are an infinite number of reasons why your trade didn’t work out.

For the successful trader, the trade just didn’t work and it’s on to the next trade. For a trader finding their way, this trade might represent more to the trader than it should. Understanding that the trade is just a trade and not a total representation of who you are as a person is the first step towards combining your trading skills and psychology.

Discovering you’re wrong in any facet of life can be a painful experience depending on the result and in some cases, it may take time to overcome. However, trading can teach us that being wrong is a natural part of life, especially when you only have some of the information needed to reach a conclusion and make a decision.

 Unfortunately, trading as in life involves making the best possible decision with the information you have and sometimes it may not work to your benefit. Holding onto the emotional baggage of a losing trade can seriously affect your decision-making moving forward and possibly affect your eagerness to enter a future trade. In his lecture series, Mark Douglass speaks emphatically about the dissociation a trader needs to have regarding the outcome of their trading results.

More research and deeper analysis won’t help in finding a guaranteed winning trade nor will assist you in discovering a trading strategy that never loses. In fact, more analysis may prevent you from even placing the trade because you won’t have all the information needed to guarantee a winning trade.

So, what’s a trader to do?

Place the trade according to your trading plan. If the trade looks probable according to your plan, and the amount you’re willing to risk is set, why wouldn’t you place the trade?

As strange as it sounds that’s usually the trade that proves to be the winner. I’ve had more than a few trades that turned out to be profitable after I overcame my hesitance to place the trade after exiting a losing trade. This is how trading works, you have to manage your losing trades so that you have enough capital to take advantage of the next trade that may work in your favor.

Worrying about being wrong is an exercise in futility.

I understand what you’re saying but what about your emotions?

Ah, emotions, those pesky feelings that cause us to act irrationally sometimes. Unfortunately, unless you can transform yourself into a cyborg or robot, emotions will continue to be a part of your life. Instead of ignoring them, perhaps we can accept them and manage them.

It’s natural to feel some sort of disappointment when a trade doesn’t work out after you spent hours preparing for the trade. It’s also natural to feel happy when a trade becomes profitable. Live and let go, even if the trade was extremely profitable because the next trade might not be. This is a healthy way to manage the emotional aspect of trading.

What’s unhealthy is to hold on to the emotions for long periods of time after the trade is completed. One of the most challenging aspects of trading is managing your emotions while you’re in the trade.

In the previous article, I posted on trade strategy, I detailed the emotions I felt when I opened, managed, and ultimately closed the trade at a loss. I felt every emotion possible from excitement when the trade reversed from a loss to profitability to sadness when I closed the trade at a loss. I even felt regret when I didn’t take the opportunity to close the position when it was in the green. After the trade was over, I let go of the trade and its results and began to look for the next trade. I documented my mistakes and reviewed them to adjust for the next trade.

The one emotion I almost forgot to mention was that of “Hope”. In life, hope is a perfectly valid emotion to feel when you’re aspiring to accomplish a goal or in a challenging situation. However, in trading, hope can have serious consequences. Hope can prompt you to remain in a trade long after the probability of it becoming successful has waned. Hope can prompt you to move a stop to allow you to stay in a losing trade.

Hope is an emotion that should be felt and acknowledged but ultimately allowed to pass through like a river flowing into an ocean. The goal of every trader should be to view the market and their trades as objectively as humanly possible.

Emotions should be felt and allowed to have a temporary residence in your mind. A trader should not ignore their emotions in a trade but manage them as the trade changes. Personally, I find emotions to be helpful and a valuable tool in building your success as a trader.

If you can build on this idea, it will allow you to be one step ahead of the competition. The markets are prone to move based on the emotions of its participants, and you can see this by looking at the charts. Greed and fear have ruled the market and will continue to influence the markets as long as they exist. As traders, we have to learn to use this knowledge to our advantage by identifying when the markets are in extreme states of greed and fear.

Notice what you’re feeling as the markets transform from bullish to neutral to bearish and imagine what the other participants might be anticipating based on these emotions.

Here are some tips to help you manage your emotions:

  • Understand and believe that the outcome of each trade is ruled by randomness. You cannot control the outcome of a trade, but you can manage the trade to give yourself the best outcome even if that means losing.
  • Emotions should be accepted and acknowledged.
  • A trader should know who they are and what they can realistically do or not do.
  • A trader should understand that each trade is it’s own and the results of the last trade have nothing to do with the trade you’re about to place.
  • A trader should not allow their emotions to influence them to deviate from their risk management or trading plan.
  • A trader should always place stops to protect themselves from their emotions.
  • A trader should never move their stops.

I “hope” this article assists you in your development in becoming a successful trader.

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