Being able to think quickly, exercise discipline and control emotions can make or break your trading strategy. Discover the psychology behind trading and tips for improving your mindset.
What is trading psychology?
Trading psychology is the mental and emotional side of the decision-making process. It’s a crucial element for traders to understand as it can have a positive or negative impact on the outcome of their trades.
A trader’s psychology is made up of all the behaviours and characteristics that influence their choices – including emotions, biases, personality traits and external pressures.
Successful traders avoid acting on any of these factors. They rely on a well-tested trading strategy and constantly develop their understanding of both their mindset and financial markets.
Psychology behind trading
The psychology behind trading is difficult to define because it’s so unique to each trader. But generally, it’s broken up into four distinct categories:
- Personality traits
- External pressures
Let’s take a look at each and how it can impact a trader.
The main two emotions that impact a trader’s decision-making process are fear and greed.
Greed is the desire to earn excessive profits. While all traders naturally want to earn money not lose it, greed impacts the ability to make rational decisions. It can cause traders to enter positions that have a high amount of risk or stay in a position for too long.
Greed is common in speculative bubbles, in which assets’ values are pushed far beyond their intrinsic and fair price. And as we know, bubbles burst. Traders who have entered positions with the ‘get rich quick’ attitude often find themselves with running losses due to poor preparation and risk management.
There’s a saying that ‘pigs get slaughtered’, which is a common Wall Street reference to the fact that greedy investors hang on to their winning positions for too long and let it flip to a losing trade.
The second emotion worth watching is fear. It’s pretty much the opposite of greed, as it’s an irrational concern over the risk of a trade. Fear can cause traders to avoid taking a position or exit a position too fast out of fear of losing money. Fear is most common in bear markets, where mass selloffs are common and can lead to high losses.
Biases are subconscious ways of thinking that can predispose traders to act in certain ways. We experience several biases in our everyday lives, but here are some that impact trading directly:
- Negativity bias – is when an individual is more inclined to see the negative side of a situation (trade) and ignore the upside. This could lead a trader to completely overhaul their strategy rather than make minor adjustments
- Hindsight bias – is the tendency for an individual to claim they ‘always knew’ the outcome would happen after the event has occurred. It can cause traders to misjudge their decision-making process and make them overconfident in their predictions
- Gambler’s fallacy – is when an individual believes that an event is less likely or more likely to occur due to past events, even though the probability of it occurring has not changed. For example, a trader might assume a trade will earn a profit because the same position had been profitable in the past
- Loss aversion – this is the tendency for individuals to place greater weight on their fear of loss over the pleasure they get from the equivalent win. So, a trader might want to avoid making a £100 loss, over making a £100 profit
3. Personality traits
The different elements of a trader’s personality can have a significant impact on their trading outcomes. A lot of the ‘ultimate’ traits you’ll see listed for traders are discipline, patience, confidence and decisiveness. All of these can make a successful trader but it’s a fine line because, under the wrong circumstances, they can also be a trader’s downfall.
For example, discipline is great, but not having the flexibility to recognise new opportunities outside of a trading plan can cause a trader to miss out. And confidence shows that you’ve got trust in your abilities and knowledge but being overconfident when you lack these attributes can be dangerous. Overconfidence can cause traders to open positions that have too high a level of risk for their experience level.
It doesn’t necessarily matter which of the personality traits you have, because they can all be managed. One of the best ways to weed out the dangerous traits from the beneficial ones is to practice trading first in a risk-free demo account. This enables you to build up your confidence, discipline and patience without putting your capital at risk.
4. External pressures
Finally, every trader experiences external pressures as well as internal ones. The opinions, attitudes and behaviours of others can all have a direct impact on your bottom line.
Herd behaviour is the idea that individuals mimic the behaviours of the many. It can be dangerous if traders just jump into a trend without doing their due diligence and research, making decisions based on a fear of missing out on the profits they believe others are getting.
Herding is one of the key theories of behavioural finance, which is used to explain why the stock market rallies and sells off. It’s most commonly used when talking about speculative bubbles, such as the dot-com bubble.
Although it’s useful to get ideas and inspiration from professionals and other traders, it’s important to keep your strategy and plan in mind. Each trader will have different risk tolerances – so, what’s considered risky for one might be a safe bet for another. It all comes down to their plans and capital allocations.
How to improve trading psychology
Here are a few tips to improve your trading psychology:
- Set rules. You need to make your own rules for trading and follow them. Most trading plans involve setting a risk tolerance level that tells you when to trade and when to close out. This can include where you’ll enter stops and limits to automate these decisions
- Stick to your trading plan. Once you’ve got your plan, don’t stray from it without testing it in a risk-free environment first. It’s important to recognise that emotions can seep into your decision making and sticking to your pre-set trading plan is the best way to help you avoid trading based on whims
- Do your research. Never make assumptions about how a market will move. And even though analysts and other news sources are a great place to start, it’s important to do your due diligence before you open a position
- Assess your performance. Every few weeks, you should take the time to look back at your trading outcomes, your positions and how you’re progressing. This can help you identify and change any bad habits that you’ve picked up. At FOREX.com, we offer the Performance Analytics tool, which can automate this process for you
How to master trading psychology
Mastering trading psychology all comes down to experience and knowledge. The best way you can ensure your strategy is uninfluenced by emotions and biases is to build a plan and stick to it. It’s important to avoid making any decision about a trade based on an emotional response or bias.
Building your trading plan – and your experience using it – in a risk-free environment can be a great way to get started. You can get £10,000 in virtual funds with a City Index demo account and practise mastering trading psychology before entering live markets.
It’s also important to recognise that different markets require different attitudes and mindsets. Let’s take a look at the profiles of two popular markets: forex and the stock market.
Psychology in forex trading
Forex markets are notoriously volatile, which means they move quickly and profits can turn to losses in the blink of an eye. The market tends to attract quick-thinking and disciplined participants.
So many different factors can impact a currency pair – from macroeconomics to local news – which is why most FX traders choose a more technical approach. Using technical analysis gives a more quantitative base for decisions, rather than emotions and personal opinions.
The psychology of forex trading makes it vital that traders stick to their trading plan and avoid making impulsive decisions.
Learn about forex trading
Psychology in stock trading
Stock markets on the other hand tend to attract more patient individuals who are willing to do their research and wait for the right opportunity. Most stock traders focus on fundamental research, looking at a company’s earnings and true value, before making a trade. This is true whether they’re looking to go long – believing a company will increase in value – or go short in the belief it’s overvalued.
However, stock markets do also attract impulsive traders who make decisions based on stories that capture public attention.
Learn about share trading