Master the psychology of trading

//Master the psychology of trading
Master the psychology of trading 2017-05-05T15:37:25+00:00

Once you master the psychology of trading you are ready to win. One of the reasons that trading is so tricky is because it pulls on your emotions. Fear and greed mainly. Fear of losing money. Fear of missing out on gaining money (greed).

When you are in a trade and you see price move against you the natural reaction is to feel fear. When you see price move in your favour and you make money you hope for more, this is greed. It is not wrong to have these emotions. It is completely natural.

Fight or flight response

Human beings are programmed to react to emotions, positive and negative. The human brain has in-built protection mechanisms that stimulate behavioural responses. Generally when we feel fear we respond by using our fight or flight mechanism.  Back in the day when we were living amongst wild animals this was a useful response. It would save our lives! In almost all areas of life this fight or flight reaction is still useful. If we are in danger, then we feel fear and we need to take action. We either need to get the heck out of there or resolve to fight our way out of the situation if we judge this to be possible.

Fear in trading

Trading stimulates this in-built fight or flight mechanism. A trade that we are in goes against us. We fear losing money. Our brain responds to this fear by triggering automatic action. Without fully considering what is happening we exit trades to cut our losses. This is our only option in the immediate present moment. We can’t move price action on our own, so fighting our way out is not a possible alternative.

Once we have exited a trade for a loss the fear is replaced by other negative emotions, frustration, guilt, anger, regret. We then do have an option to fight, we can enter another trade. Red mist descends. When we enter trades without thinking we are not following our system and this is very dangerous. It can lead to serious losses.

The moment that we enter a trade our minds are immediately altered whether we like it or not. Our thoughts are clouded by the commitment that we have made, the judgement that we have made. We look for reasons to prove that we are right. We hope to make money. This is called the confirmation bias. It is based on wanting to be proved right, fear of being wrong and greed. Yes, sorry it is greed.

For these reasons trading is very very tricky.

Reactions to our emotions in the form of the fight or flight response are the reason why we exit trades at the worst possible time and enter trades at the worst possible time. They are the reason that we do not stick to our system and they are the reason why we can have a very profitable system on paper but still lose money. 

Master the psychology of trading

Let me give you some examples of how psychology in trading works:

You enter a trade based on your system giving you a signal to buy.

Scenario 1)

Price goes up. You are in the money.

Some trading portals show you how much money that you are currently up or down on each trade and as price moves so does this figure. This is not useful.

You see that you have made money. What does your mind then do? It says to you “Exit now and take your money.” This is fear of losing what you have. If you concentrate on this thought for too long then you will exit your position.

If you ignore the thought then as soon as price goes down slightly the thought will be back, even stronger this time, you will exit your position.

If you ignore the thought and price rises then the thought will return, again it will be even stronger now. “Take your money while you can. Prices always go down after they have gone up!” You will exit your position.

This is the reason why it is tricky to run our profitable trades and the reason why we often exit profitable trades at the worst time, at the end of pullbacks and just before price zooms off in the direction that we thought that it would go.

Scenario 2)

Price goes down. Not what you were expecting. You are losing money. You look for reasons why it went down hoping to find them and see price rising back to your entry level. You search for indications that prices will rise. You ignore indications that it will continue falling.

Before you know it you are in a losing trade. You resort to hope. You hope that prices will rise. Thoughts like “if it just goes back to where I entered I will get out” enter your head.

Eventually price falls further and continues falling. You exit your position, feeling desperate.

This is the reason why it is easy to ignore when you are wrong and cut your losses and the reason why we often exit losing trades at the worst possible time, just as price reaches the extreme in the opposite direction to our trade and turns back towards our entry point.

Trade your system and ignore the money

  • All traders should have good reasons to enter trades. The reasons should be based on a system that has proved profitable over a long period of time in backtesting.
  • All trades should have target levels and criteria for exiting at a profit if this target is not met.
  • All trades should have specific criteria which tell you that you are wrong.
  • All trades should have a physical stop level to ensure that if something goes seriously wrong you don’t lose your house! The actual stop level dictated to by your system may or may not be the same level as your physical stop.
  • You should only exit trades based on the criteria dictated to by your system.

Mental and physical stop positions should be evaluated before entering a trade. If the level at which you would be wrong means that you would lose too much money for you then don’t enter the trade.

If you enter trades thinking something like “I’ll just see how it goes” then you will suffer from emotional trading. No doubt about it.

Assuming that you have entered a trade based on the rules of your system then you should see the trade through and ignore the money. You are entering trades based on a tested system and during the trade is not the time to start re-evaluating the probabilities of a system working or not.

If you are unsure of the effectiveness of your system then you need to do more evaluation in backtesting it.

Trades that start badly

Sometimes winning trades do start badly. This does not necessarily mean that it is going to be a losing trade.

Beginning traders should always trade with the trend. The reason is because the trend indicates the general direction of the market.

If you enter a trade based on a trend based system and you are trading with the trend then bear in mind that trends do have pullbacks and pullbacks will feel painful.

In a pullback when price action looks at its worst for you then this is probably the worst time to exit. In a trend when price pulls back strongly then the chances are that if the trend continues it will rebound strongly too.  Hold on until your exit criteria has been met.

Most strong price moves also rebound strongly. If you are looking at candlesticks on your chart and you get a negative candlestick in the opposite direction to the trend then it is often followed by a very strong candlestick or series of candlesticks back in the direction of the trend. The trouble is that when all you can see is price action going against you and your open position going negative you will become fearful and it will set off your fight or flight mechanism. Wait for your exit criteria to be met before exiting. 

When price goes in your favour in a trade then hang on in there. When price moves strongly in your favour you will feel like exiting the trade. You know that price is likely to pullback at some stage this is going to make you nervous unless you accept that this is the case and see the bigger picture. When you see the pullback happening then you will feel like exiting the trade as you can see your profits evaporating. You will be regretful that you didn’t take profits earlier. Hang on in there. See the trade through. Wait for price to make your target or trigger an exit via your exit criteria.

Always bear in mind that trading is least profitable in the long run when you respond to spikes in price action (with you and against you) and exit before your system criteria have been met. Accept that sometimes trades fail. No system is 100% effective. Accept that sometimes you will make losses. Losses are an acceptable part of a winning and profitable system. Always trade your system.

Trades that go against you – Knowing when you are wrong

I can’t emphasise enough the need to stick to a system in trading. Bear in mind that trading is a very competitive world. Individual traders (lone traders) like you and I are battling against some of the richest people and organisations in the world. These big players all have systems. Many of these systems have been devised over time by the brightest people on the planet. Money can buy you the very best of everything.

Having said that, trading is actually really simple. When price goes up and the action meets the criteria of your trading system, buy. When price fall, sell. If we do this then we can make money. Lots of it.

When I mention big players. I am talking about a huge number of big players with lots of money. They all know the rules of the game and it is a game after all!

The big players in the markets have systems that incorporate what time has told us about psychology. It is all about smoke and mirrors at a complex level. Big players know that most inexperienced and amateur traders will buy at the tops and sell at the bottoms. When things look great then be very sceptical!

The big players know that when amateurs buy at tops they will be fearful if prices move against them. They know where amateurs are likely to place their stops.

Their job is to take easy money from beginners and amateurs. Because they know how the game operates they will deliberately trade against smaller traders. They will deliberately move price in the short term in the opposite direction to where they intend to send it in the long term. In doing this they will sell at tops and buy at bottoms. They wipe out smaller traders’ stops, thus providing themselves with very good value contracts before taking the market in the other direction.

Smoke and Mirrors

Just before a market makes a big move, more often than not, the price action will make a quick move that hints at a move in the opposite direction to where it is going to go. This is smoke and mirrors. It is like a nutmeg in football (sending the ball between an opponents legs). It is like a server in tennis feigning to send to ball in one direction before sending it in the other.

This quick move will draw in amateur traders. They will trade in the direction that they see the market moving towards a breakout, this is when the market looks great, however it is also when there is the most danger. The big players can move the market several times in different directions very quickly before the big move is confirmed. Each time the market feigns a breakout amateur traders jump aboard and then get wiped out.

Example:

Price will make steady progress upwards, moving to the top of a range. Amateurs will be thinking “Price is going up.” Then price dives down all of a sudden. The amateurs then think “Oh, price is going down. Look at that!” They will exit long positions and enter short positions.  Price will then move upwards strongly, breaking the previous highs and zooming for the sky. Of course this will take out all of the amateur traders stops on their shorts, thus accelerating the move upwards and providing cheap and easily attainable contracts for the professionals.

These type of moves happen all the time and the amateur traders can make several losing trades in a row chasing the market up and down in this way. By the time the market makes its big move the amateur has been shaken out, and normally sits in their chair, bewildered by their losses, watching the market zooming away without them.

This is how markets operate. This is the game. As you learn to trade you need to be aware of how this works, how the psychology of it works and you need to have a trading system that allows for this and embraces this.

It is a big game. A very important game. As a lone trader we are on the outside looking in. It isn’t our game, it belongs to the big players. The big players allow us into the game, in fact they encourage us to play as they know that we provide easy money for them.

It is a game the lone trader can win as long as we play it by their rules. Learn more about the psychology behind trading, the systems that the big player use, how to manage your own emotions and master this aspect of trading in our online Trading course.