The importance of psychology in trading is often overlooked by the amateur. Every professional trader recognises it. In order to become a consistently profitable trader you must take the psychology of trading seriously.
Here is an example of how psychology can affect trading.
The FTSE had a quiet premarket trading session. It had fallen slightly from the close of the previous day, however nothing dramatic.
Looking at the FTSE 07.55 – 07.59 bars on the one minute chart you can see that the market looked like it was rising. The 07.56 bar opened slightly lower than the 07.55 bar closed and w
as entirely positive (no tail). This is normally an indication that prices are about to rise and so they did for the next few minutes.
The 07.59 bar on the FTSE was also entirely positive forming a new high on the five min chart.
For our example we are going to assume that we have Trader A and Trader B both looking to trade the FTSE open on this morning.
The FTSE opened. Price immediately went up and broke the high of the previous bar. For many this would have triggered the entry into a trade. Price making a new high and higher than the previous five candlestick
highs. The market looked positive. The trade would have been long, a buy trade i.e. that the FTSE would rise. Trader A makes this trade.
However, now take a look at the DAX one minute chart which Trader B has up on one of his monitors. The market had fallen strongly from 07.30 to0 8.00. The main DAX market in Germany has an official opening time of 9am, or 8am UK time, however the early DAX market opens at 7am UK time and so it often gets into full trading mode (greater volatility) earlier in the morning than the FTSE. On this morning price on the DAX has already broken out lower from the premarket range.
The DAX and FTSE markets are not perfectly aligned and they do move differently, however when the FTSE moves higher on open and contradicts a breakout already in progress on the DAX it is worth waiting a few moments to see what happens rather than jumping in. This is exactly what Trader B does. He waits.
Price on the FTSE almost immediately reverses. The 8.00 candlestick bar on the FTSE closes as a negative bar with an equal sized tail and nose.
Trader A is now nervously watching the action. He is in a losing position and is hoping that prices go back upwards quickly. He decides to wait for confirmation that the trade is not working before closing his trade for a loss as taking a loss means accepting that he was wrong. It means that he has a losing start to the day. Taking a loss is painful. Human beings seek to avoid pain whenever possible.
The next two one minute bars confirm that the FTSE market is moving into negative territory. They break the low of the premarket trading period and they are both negative. At this stage Trader B’s trading system took him into the trade. He had additional confirmation in that the DAX was consolidating its breakout and continuing to move lower. You will see the FTSE chart snapshot now looking more in synch with the DAX chart.
Trader B was in position now to see how the trade would work out. He had already set his target based on previous Support and Resistance levels.
Trader A exits his trade for a loss. What does he do now? Should he go short? He has already made one bad decision today. He decides to wait and see.
The next three minutes sees the FTSE continue to descend. Trader B is sitting comfortably in his chair, he is in profit and things look really good to him. He can see the market moving towards his target.
Trader A is now beginning to panic. Is he missing out on the big move of the day? He doesn’t want to miss out, after all he has losses to recoup. He enters a trade at 8.05, he joins Trader B in going short.
In the second half of the 08.05 bar price retraces slightly. Trader A sees his trade go into a loss position, although only just. 08.06 bar takes price higher. Trader A is now staring at his loss position on his screen. He has taken his eye completely off the action on the chart and his indicators, he is just staring at his mounting loss. Another loss is looming. Should he exit his trade? He notices that price stopped just short of 6250 before retracing. A round number! Oh no, price is going back up. He waits until the end of the 08.06 bar to see if price moves back down at all. It doesn’t. He exits his second trade for a loss. His second loss of the day. He is now paralysed in his chair. He watches as price pauses at 08.07 and then drops with purpose on the 08.08 bar, 08.09 bar and 08.10 bar. In his mind he has missed out on the move. Worse than that he has had two losses. Should he enter another sell trade or wait for price to start bottoming out and then trade the market back up?