Trading Psychology
Perhaps the most important and underrepresented element of trading is managing your emotions and understanding the psychology that goes into playing the markets. No matter how much you know or how much you practice your trading, the emotional battle of watching real money go up and down in the market never goes away and is often the principal reason traders fail to be successful.
There are a lot of tools to help you manage your emotions that I will get into, but it’s important to recognize that this battle never ends. It will require constant attention and unwavering discipline if you want to make and keep money through trading. Containing your excitement and subduing your fears seems simple on its face, but will prove itself to be a herculean task in practice.
Before I lay out some of the specific tools for quelling the influence of emotions on your trading, I’ll attempt to break down some of the barriers, psychological and otherwise, that make this such a difficult endeavor to undertake.
Barrier #01: The Psychology of Trading isn’t Widely Discussed.
The truth is, most investors and traders don’t warn you about the psychology behind trading. Perhaps this is because they themselves aren’t consciously aware of the role their emotions play in their own investments, perhaps it’s because taming emotions is a difficult thing to teach, or perhaps it’s because the people from whom you are drawing your information are part of the class of investors who profit off the emotional folly of retail investors. In either case, it remains a very underemphasized component to successful trading. In the case of being unaware or someone profiting from such lack of awareness, the underemphasis is expected, but why is it underrepresented by those who do know and would be willing to share? The likely reason is teaching someone not to get excited or not to be scared of naturally thrilling or terrifying circumstances is hard to explain or teach beyond just saying it. There isn’t a fact I can point you to that will simply change how your emotions function. Managing emotions belongs more to the field of therapy or meditation than finance and is far different than teaching someone a simple fact about the markets.
It’s much easier to shift someone’s focus to more tangible or quantifiable tools like chart patterns, balance sheets, news releases, or whatever else someone believes helps them invest or trade successfully. Now, while all of these things can and do play an important role, none of them prepare you to use such information rationally. Understanding what a double top is or how to find a supply zone is very different than acting on it. Recognizing a company’s discounted future cash flow has it undervalued at current levels is very different than buying that company and maintaining your conviction through red days. Weighing the implications of a news release in a vacuum is very different than considering those same implications while price ticks higher or lower right before your eyes.
It would be great if financial pundits like those of CNBC, Bloomberg, or the like would shift their focus from earnings reports and news releases for just a few minutes each week to talk about the emotional turmoil one can expect to experience when investing, but they don’t. The powers that be have decided that it is not important information to share or, as alluded to, not conducive to their own success in the markets. Though emotional lessons are often ineffable and better taught through experience, the incentives for big market participants to keep retail as the ‘stupid’ money are unassailable. They know how to play into the hopes and fears of their viewership and any lesson they would teach you about properly managing your emotions in the markets puts you one step closer to crowding them out of their own trades. The more rational retail is, the less money the big players make. So regardless of how much coaching you toward a better trading mindset would help, they know an emotional investor sells into their buying and buys into their selling and that’s the way they like it—the psychology of trading as the dirty little secret with which everyone struggles but that nobody mentions.
Barrier #02: The Role of Fear and Greed.
No matter how much you know, your emotions will always try to push and pull you away the facts as you see them. Despite every intention to follow those facts, fear and greed will consistently lead you astray in the markets. Aside from using these emotions to employ Buffet’s prescient blueprint, “Be fearful when others are greedy and greedy when others are fearful,” neither emotion has any place in a successful strategy. Fear pushes you to sell when you shouldn’t, and greed drives you to hold when you shouldn’t. They both draw you away from the facts and fundamentals that allow you to view a trade objectively.
Neither fear nor greed’s effects are particularly complicated, in fact, the simplicity of how they affect the human psyche are a testament to how deeply instinctual they both are. Understanding them and their effects is not the challenge, it’s learning to fight your natural inclinations and see your trades rationally in spite of the fear or greed you’re experiencing. The fact that doing this runs counter to our very instincts should better explain why conquering your emotions in trading is a never-ending battle and also why it is imperative you learn to recognize when they are motivating your actions.
Fear and greed are two sides of the same coin and knowing which of the two is dominating your bias will be crucial to viewing the markets more objectively. If you find yourself in a state of euphoria drooling at the mouth over your profits, it’s almost certainly time to sell. If there is panic and bearish sentiment everywhere you look, it could very well be the time to buy. Eliminating your emotions altogether is impossible so attempt to use them as contrarian indicators rather than outright ignore them. Don’t let them make your decisions, but allow them to inform your decisions when appropriate.
Assessing your own emotions is often a great way to gauge overall market sentient and can be used to enter and exit quite effectively. It won’t be easy to exit when it seems like you found a money printer and it won’t be easy to enter when it looks like there’s blood in the streets, but good exits are terrible entries and good entries are terrible exits—look at your trades from the opposing side to gain some perspective and constantly ask yourself if you would be interested in buying or selling at these levels. If you wouldn’t be a buyer, it’s likely others won’t be either and it might be time to sell high while you still can. It won’t always be obvious when fear or greed are in the driver’s seat and it will take significant effort to subdue their impulses even when you do know, but this task will hopefully prove easier with time. That said, the journey never ends and you can never let your guard down. No matter how much you know about the influence of fear and greed, they will always be lurking in the background. They are simply too fundamental to the human experience to unlearn so you must, instead, learn to tame them.
Barrier #03: The Psychology of Money.
Now, while all this talk of fear and greed and non-emotional trading seems fairly straightforward, why do so many still struggle to overcome their emotions? The short answer: money. This is somewhat related to the notion of fear, but it’s a bit narrower and worth mentioning in some detail. One of the reasons trading is uniquely challenging is a regular job never takes your money. In fact, it usually guarantees a predictable amount. You know whenever you go to work you will end the day with some hard-earned cash, and at no point during that day will you see yourself losing money. It’s this element of losing money for which nobody prepares you. Losing money feels like theft and theft provokes strong feelings of anger, frustration, self-pity and all the emotions that cloud your judgment when you need it most. Watching real money vanish in real time will spark concerns in the strongest of souls and demands a kind of mental toughness unlike any other profession. Whether you’re up and scared to lose what you’ve made or down and hopeful it will change direction, the psychology behind losing money is largely responsible for the irrationality and impulsiveness in the markets.
There is no secret strategy to never losing money and you will have to come to terms with that reality sooner or later. I’m not going to sugarcoat it, it’s not easy. Watching your money go up and down is stressful, but do yourself a favor and try not to stare at your PnL throughout your trades. Market fluctuations are normal and watching your PnL go up and down every second is even worse than staring at every single 1min candle. It distracts you from staying true to the merits of the trade and motivates you to react based on money rather than facts. Reacting based on a dollar amount is completely arbitrary. Reacting based on facts is how you achieve consistency. If you truly want to achieve consistency, don’t be afraid to lose money—embrace it. Your trades will be fluctuating every second you’re in them and getting emotionally attached to unrealized profits is how you become self destructive. Don’t worry yourself with all the numbers in between your entry and your exit. Commit yourself to specific reason-based levels and accept one of those will be your end result. If you are the type of person who just can’t watch their money move without getting emotional, this might not be the profession for you. Trading is a game of risk and if you’re too afraid to lose money, you’re too afraid to trade.
Barrier #04: The Ego.
Another critical element of trader psychology is our obsession with being right. We tell ourselves we just want to make money overall, but deep down we also want to win every trade. We know, or at least should know, this is unrealistic, but it’s the reality. We want to prove to ourselves and others that we are right, that we are smart, and that we can make money. Every loss feels like a slap in the face telling us we’re stupid or, even worse, that the market is to blame. Losses hurt and nobody likes to accept defeat, but it’s never the market’s fault. You are going to lose and you need to accept defeat graciously. Being wrong may not be something we enjoy, but it’s something with which traders must become overly familiar. The good news is, if you stick around long enough, you’ll probably win a lot too, but that doesn’t make you Stan Druckenmiller and you should win graciously as well. If you are serious about trading, you are going to have innumerable wins and innumerable losses. Having every one of those impact your ego or self worth is as unhealthy as it is counterproductive. No matter what happens, no matter how many losses or wins you have, you need to keep your ego out of it.
When it comes to trading, and perhaps most areas of life, your ego is your enemy. You can’t let it get wrapped up in your success or failure in the market, unless you want to turn into an emotional basket case. Being wrong or right about a trade shouldn’t make you feel like an idiot or a genius, it should simply be information you learn from and apply to future trades. Everyone has bad trades and some of the smartest people in the world by most metrics are terrible investors. Intelligence is neither a necessary nor a sufficient condition to becoming a profitable trader so don’t let your trades be a reflection of you or your intelligence. Be comfortable with being wrong, don’t hold any opinions too close to your heart, and don’t let your initial hypotheses prevent you from making or saving money. Your desire to be right or fear of being wrong will have zero effect on the outcome of your trades so let it have zero effect on how you take them. The ego is your enemy. Trade to make money, not to be right.
Barrier #05: Learning to Lose.
One of the hardest truths about the market is you have to learn not just to accept losses but to plan for them. Losses simply come with the territory and that is a hard pill to swallow for some. The mental fortitude required to endure loss after loss cannot be overstated, but nobody said this was gonna be easy. Don’t take losses personally or let them cause you any more pain than they have to, accept them before they even happen and know it’s all part of the long and grueling process toward success. You will have a lot of losing trades. That is a fact and planning for losses will be essential to your success. Losses are guaranteed and your goal is to simply have your wins outshine them. Before ever entering a trade, you should fully accept all possibilities and never fixate on the end result. Rather, you should view every trade within the context of all your trades as no single one validates or invalidates your strategy.
Trading is a means to earning a weekly or monthly paycheck and everything in between is just noise. A successful trading month could easily include 10 wins and 10 losses, which means your best case scenario could be losing 50% of the time. If you aren’t prepared to do that and account for losses as part of your plan every week and every month, you likely won’t be successful. This may be difficult at first, but after every single win and every single loss, always remind yourself, it’s your total PnL that really matters. Even if all your traders are losers and your total PnL is all L, you need to understand that is part of the process. Trading is extremely difficult and requires a lot of patience. You will frequently or even mostly lose money in the beginning months or even years so plan accordingly. Put aside a sum of money you are perfectly willing to lose and get to work. You are attempting to solve a very difficult puzzle and you will have to lose some money along that journey. But think of every loss as tuition. You pay to learn from your mistakes and then leverage that information to make better trades in the future. Anger and self pity won’t solve your problems, but planning out your losses, keeping a level head throughout it all, and learning from each mistake will. Losses are lessons, not emotional kindling to stoke your sorrows. Plan to lose and plan to learn.
Now let’s get into some specific tools to help you effectively manage your emotions.
TOOLS TO HELP YOU MANAGE YOUR EMOTIONS:
1. Create a Plan and Stick to it.
- This has been alluded to quite a bit, but it’s so important it deserves the extra attention. Taking the emotion out of your trading by adhering to a strict set of rules is one of the best ways to protect yourself from yourself. When you don’t have a clear-cut plan with well-defined entries and exits, you give your emotions too much power over your trades. Trading is all about having an edge in the markets and the only way you get an edge is if you have a solid strategy. Without one, you are no different than the craps player in the casino, so create a plan. There are plenty of strategies out there, some certainty better than others, but the right plan for you will depend on your individual preferences and perhaps require your own original approach or tweaking. Discussing the intricacies of trading plans is beyond the scope of this article, but just know you need to find one.
- When you do and if that trading plan works, all you have to do is follow it and you will win more than you lose—your emotions will only eat away at whatever edge you have in the markets through that plan. If your plan doesn’t work, then find a new one. No trader starts with a perfect strategy, but you have to test whatever you have to know what works and what doesn’t. Paper trading and back testing make this much easier, but you have to commit to whatever plan you have to find out if it does or does not work—there is no other way. If you let your emotions steer you away from the plan, you won’t really be trading that plan and so you won’t really know how well or poorly it works. Study, paper trade, backtest, and do whatever you have to to create a strategy and then trade that strategy with conviction. Sticking to rules is the best way to ensure consistency and to keep your emotions out of the equation, but you have to follow those rules. Create a plan and stick to it.
2. Lower your position size.
- As I’ve discussed, one of the main reasons trading can get so emotional is because you have real money on the line. It’s only natural to be concerned about losing capital and seeing your hard-earned money disappear before your eyes is extremely unsettling. A great way to reduce this visceral response triggered when watching a fluctuating PnL is to trade a position size that is just small enough to not really care about the end result. Being down hundreds of dollars can spark a strong reaction to cut the loss before more money vanishes, but in a trade where you are only risking $10, even the worst-case scenario is tolerable. The fear associated with trading could be completely warranted if you are risking more money than you can handle to lose. If a certain position size has you glued to the screen all day or keeps you up at night, you might need to take some money off the table so you can assess your trades more rationally.
-By lowering your position size you’ll find committing to your stop-losses and take profits (your plan) much easier and you’ll also get more accustomed to the emotions of trading with real money. Real money changes everything and you need to go through the ups and downs to learn how your emotions lead you astray. Eventually you will come to understand that trades go red to green quite often and panic selling is frequently your worst enemy. But if you’re panicking, you might be risking too much and you should never risk more than you are willing to lose. If you find it difficult to commit to your trades when they start to go south or even difficult to hold through the end when you’re up, you should rethink how much money you are trading in the first place. Lower your position size.
3. There’s Always Another Trade.
- Overtrading is one of the quickest ways to destroy your edge in the market. Whether you feel like you missed a good trade, got out of a promising trade too early, suffered a bad loss, or are just plain eager to trade, traders have a tendency to throw money around when they shouldn’t. If a trade you missed took off, assess why you were hesitant, learn from your mistakes, congratulate yourself for getting it right, and go find the next one—there’s no need to chase. If you exited a trade and you think it was a mistake, ask yourself what changed and assess the trade as if it’s a whole new one. There’s no need to hold onto some attachment to a particular ticker just because you were recently in it. You don’t want to let your past trades stop you from taking a good one, but you especially don’t want them to convince you to re-enter a bad one out of FOMO. Every trade is its own and should be treated as if it’s a completely different ticker.
- If you can’t trade a ticker objectively because price is moving fast or you just got out of it, go find another trade you can trade objectively because there are a thousand more. And if you’re beating yourself up over a bad loss, figure out what went wrong, learn from it, and start with a clean slate in the next trade. Your past losses don’t dictate your future trades much like a losing coin toss doesn’t dictate your odds on the next one. Every trade is different and every day there are countless opportunities to make money —there’s no reason to fixate on the ones you miss, the ones you lose, or any others. For every stock that just took off, there’s a dozen more that are about to take off, and for every trade that looks ‘alright,’ there are a dozen more that look like A+ setups. Don’t limit yourself to a small handful of trades or think this one stock is the only opportunity to make money. Opportunity is everywhere and you never have to force a trade that isn’t perfect. Sometimes it’s best to just sit on your hands and wait. There’s always another trade.
4. Just Cut it Loose.
- Bagholding is arguably a right of passage in trading and something everyone will go through at some point in their investing career. As they often say, losses aren’t losses until you realize them. While that playful adage is technically true, it’s a terrible way to approach your trading. Managing risk is essential and holding onto that small inkling of hope that your trade will turn around is your emotions stealing your money. This certainly ties into the previously mentioned idea of learning to accept defeat, but you should learn to accept defeat before it turns from bad to worse. Rules can help you decide when enough is enough, but sometimes you need to read the writing on the wall and abandon ship while you still have a life raft.
- Just because you have a stop-loss or are willing to lose what you’ve risked doesn’t mean you should wait for the inevitable. Your opinion on trades can change quickly and there’s nothing wrong with cutting the cord so you move on quicker. So many people will try to hold onto trades until it moves back to breakeven only to find breakeven never comes. Who cares if you lose a few percent, save yourself the headache and exit as soon as you decide you don’t like the trade. The weight lifted off your shoulders when you take all your money out of the market is very real and sometimes you need to exit a trade to fully focus on the next. If you want out of a trade but are too proud or hopeful to exit at the current level, you’ve already mentally exited the trade and you’ll feel a lot better if you put your emotions aside and rip the bandaid. Just cut it loose.
5. Know yourself.
- Nobody on this planet knows you better than yourself. You know when you are excited and you know when you are fearful. Having self awareness and being able to tell yourself you need a break or you are too emotional to be trading is a powerful tool. You won’t always be in the right mental state to trade and knowing when to step away from the screen can save you more money than you can imagine. Everybody has bad days and sometimes a losing trade affects you a little too much. And other times you’re on a hot winning streak and overconfidence is putting you at risk of giving all your gains right back. Rather than engage in revenge trading or callously deviating from your plan, take a walk, listen to some music, practice deep breathing, or even just call it for the day—do whatever it is you need to do to get your mind right.
- Trading is just as much a mindset as it is a skillset. You aren’t just trading a plan, you are trading your psychology and there are times where the latter is far more important. Effectively managing your emotions will take time and will be full of the same ups and downs as the market, but you have to recognize when your emotions are getting the best of you and work to keep them in check through constant monitoring and self awareness. Whether you accomplish this through meditation, peaceful background music while you trade, or just a nice cup of tea, take care of your mind and regularly take the time to assess your mental state. Know yourself.
Conclusion.
There are undoubtedly countless more tools to help you successfully tackle your emotions, but tools can only help you so much. At the end of the day, it just comes down to you. You and you alone have to discover how to separate you heart from your brain; your emotion from your reason; your passions from your work ethic. Learning to treat your trading like a job rather than a hobby is fundamental to getting results. Another day in the office shouldn’t feel like a roller coaster—you should be calm and well tempered and avoid chasing the thrills of gambling. Casinos get your heart racing, but work is your baseline—don’t be scared or excited, just go to work. Work frustrations will happen, especially as a trader, but you need to find your rhythm, establish a routine, and make sure your unplanned emotions and frustrations don’t steal the spotlight from your planned and calculated strategy. Conquering your emotions won’t be easy, but it is the surest way you will find success as a trader.