Articles on Psychology of Trading

[Jennifer]

Recognizing and Overcoming Stubbornness

A large part of being a successful day trader is having the right personality traits, or if not, at least being able to control the opposing personality traits. Human traders will always be influenced by their personalities and their resulting emotions, but professional traders have learned to overcome the emotions that are counter productive to their trading.

Stubbornness

One such personality trait is stubbornness. Stubbornness (or obsintance) causes people to become attached to their decisions regardless of the consequences. Day traders need to be decisive in order to make their trading decisions promptly, and then act upon those decisions without any hesitation, but they also need to be flexible and able to react when a decision was incorrect. In order to be successful, day traders need to find the right combination of decisiveness and flexibility for their personality.

Overcoming Stubbornness

Stubborn people usually refuse to admit that they are stubborn, so recognizing that stubbornness is causing problems with their trading can be difficult. Stubbornness usually causes several different trading mistakes, with the following mistakes being the most common. If you are making any of these mistakes in your trading, it is probable that you have some degree of stubbornness in your personality , and that it is affecting your day trading:

•Refusing to use targets and stop losses, and certainly refusing to actually place target and stop loss orders
•Choosing not to follow a trading system, because you know what the market is going to do
•Holding losing trades until the pain is just too much to bear (or even until your brokerage exits the trade for you, because you no longer cover the required margin)

For any other reason, these mistakes are actually easy to overcome, but not when they are being caused by stubbornness. In order to overcome these mistakes, stubborn traders first need to recognize that the mistakes are being caused by a natural human emotion, and that there is nothing wrong with admitting this. As being stubborn is a form of control, it may help to think that by recognizing the cause, you can have more control over yourself, and hence over your trading.
Once the cause has been recognized, trading in simulation will provide time to correct the trading mistakes without risking any real money. Trade in simulation until you are consistently profitable (by consistently, I mean several weeks, not just one day), and then move to live trading, but be aware of the additional emotion that will appear when you start trading live.

[Jennifer]

Master Your Trading Mindtraps

The popularization of speculative trading in the financial markets, partly due to the development of retail trading solutions offered on the internet, has created a new population of traders in the market. Most of these traders are non-professionals that are attracted by the potential to generate revenue quickly.

Falsely Created Expectations

Many novice traders may believe that it is very easy to make money, especially when they are trying a broker service using a free practice account.

However, if these traders manage to generate a sudden substantial return, it can lead them to believe that trading is an easy occupation - one in which revenue can be quickly generated with little work by the trader. For the inexperienced, one good pick can make it seem like market speculation is the key to success and wealth.

Unfortunately, when these inexperienced speculators overtake this virtual investing environment and decide to start trading live accounts and risking real money on the market, the activity becomes much more complex. In many cases, the days of outstanding day-trading performance come to look suddenly and distressingly like old souvenirs - it is an abrupt initiation into the pitiless reality of the financial markets.

Real Life vs. Practice

When new traders take the leap from their virtual trading accounts to trading with real money, they enter into the most difficult step of their initiation to trading: trading psychology.

In other words, while it may be easy to trade when the risk of loss does not exist, when the trader's hard-earned dollars are thrown into the mix, his or her focus and price objective can go out the window. Often, traders using virtual accounts will feel relatively comfortable even when the market moves against the positions they enter. This allows them to keep their focus on their price objective and wait for the market to get moving in the right direction. Because there is little consequence tied to "virtual money", personal emotion does not interfere. Unfortunately, when a trader's actions come to affect the gain or loss of his or her own personal assets, that trader is less likely to behave in such a methodical way.

Emotions Can Rule the Trade

Emotions can be seen as the trader's worst enemies; they often lead to misjudgment and loss.

Feelings generate what psychologist Roland Barach calls "mindtraps" in his book, "Mindtraps: Unlocking the Key to Investment Success" (1988). Roland Barach provides a collection of 88 lessons explaining the pitfalls, such as fear and greed, that hold many traders back.

Greed
Greed can lead a trader to hold on to a position too long in hopes of a higher price, even as it falls. This emotion has been the main reason behind many trades that have gone from large gains to large losses. To thwart this emotion, try to take an objective look at the reasoning behind your positions. When one of your positions experiences a large run-up, ask yourself whether the reasons behind your initial investment still remain; if not, it may be time to close or reduce the position.

Fear
Fear can prevent a trader from entering trades and lead to taking them out of positions far too early. If an investor is too concerned with potential loss and the risks that come with an investment, he or she can often be dissuaded from a good opportunity. Also, if a trader is more susceptible to fear, he or she may sell out of an investment far too early based on the fear of losing the gain he/she has made. In many cases, this can prevent a trader from cashing in on a much bigger gain.

Paralyze by Analyze
Paralyze by analyze is an interesting phenomenon in which traders get so caught up in analyzing everything about a potential investment, they never actually pull the trigger on the trade. In this case, what often happens is that the investor will constantly question all of the little details found in the analysis in an attempt to perfectly analyze a situation. This is a truly unachievable task, which can prevent a trader both from making monetary gains and from making experiential gains by getting into the trade.

A wide range of other emotions can rule a trader, but the important thing for any market participant is to recognize these emotions.

Acknowledge Your Emotions

All traders will experience at least one mindtrap, but the very best traders learn to recognize, understand and neutralize them. This process forms the foundation of any trader's training. Therefore, if you want to become a successful trader, you should first spend some time getting to know yourself and the particular mindtraps you tend to fall into. A skillful trader tends to have a strong desire to master his or her emotions and prevent them from affecting his or her performance.

Trading Nirvana

Traders are only human and, as such, perfection may not exist in trading. However, profitable trading can be achieved when a trader learns to manage his or her emotions. This will be easier for some than for others, but it is only through experience in the market that this skill can be developed. Therefore, before you can learn how to win, you have to take some risks (or at least get into the market) and learn to master the emotions that making (and sometimes losing) money stirs up.

[Tom]

Increasing Targets.

Day traders use target orders to automatically exit their trades when their trades are in profit by a predetermined amount. Target orders are usually limit orders, and are usually placed as soon as a trade is entered. This means that the target order is active throughout the trade, while it waits for the price to trade at the target price. Once the price trades at the target price, the target order will be filled, and the trade will be exited with the appropriate amount of profit.

Target orders should be placed at the price that corresponds to the optimal amount of profit. For example, if a trading system enters trades that usually go more than 80 ticks into profit, but rarely go 85 ticks into profit, a good target would be 80 ticks. Placing target orders correctly allows the right combination of long term profit and short term risk.

Why Are Target Orders Necessary?

One of the main reasons for using target orders is that they remove the trader from the decision of when to exit the trade and how much profit to take. Beginning day traders are often affected by the emotions of fear and greed, and this can cause bad decisions about exiting trades. Correctly placed target orders will make sure that every trade is exited at the optimal amount of profit (if that amount of profit is available), without being affected by the emotions of fear and greed.

Increasing Targets is a Mistake

Once a target order has been placed, it should not be moved under any circumstances (unless it has been placed incorrectly). One of the reasons for using target orders is to remove the trader from the profit taking decision. If a target order is moved, the trader is still controlling the profit taking decision, and is not letting the target order do its job.

The usual reason that traders want to move their targets is because the price is moving in their direction, and they want to take as much profit as they can. The problem with this is that the trader is no longer taking the optimal amount of profit, and the long term result will be less profit.

Greed is the emotion that causes this desire to take more profit, and can be so strong that a trader will increase their target, even though they know that doing so is a mistake. Some trading software has a feature that prevents target orders from being modified, and this is a good solution for traders that cannot overcome their greed.

[Tom]

Sentimental Trading

One of the psychological abilities that traders need to have is the ability to let go and move one when a trade does not go as expected. In other words, traders cannot afford (literally) to be sentimental about their trades, be they profitable or losing trades.

Why Sentimental Trading?

There are various reasons why a trader might be sentimental about one (or all) of their trades. Some traders simply have sentimental personalities and are sentimental about everything in their lives. Some traders are not sentimental in general, but are sentimental about their egos, and therefore cannot accept they have made a losing trade. Some traders are sentimental about money, and are therefore unable to exit any losing trades because that would mean accepting a loss.

How To Overcome Sentimental Trading

Whatever the cause, sentimental trading will have a negative impact on any trader's profit and loss, and therefore it must be overcome.

Traders that are sentimental about everything should have the easiest time overcoming their sentimental trading, because their sentimentality is not specifically related to trading (excepting traders whose sentimentality is caused by a mental issue such as a compulsive disorder). These traders are perfectly capable of letting go of things (e.g. they probably throw away empty packaging on a daily basis), so they should be able to apply the same thought process to their sentimental trading (e.g. they are simply letting go of a trade that they no longer need or want).

Traders that are sentimental about their egos will have the hardest time fixing their sentimental trading, because their sentimental trading includes their self worth. These traders need to recognize that all traders make losing trades from time to time (just hopefully not too many). Part of being a professional trader is being able to learn from any mistakes that were made as part of a losing trade (if there were any mistakes), and be able to move on to the next trade without any further thought about the losing trade.

Traders that are sentimental about money will also have a hard time overcoming their sentimental trading (but not as hard as the ego based sentimental traders). These traders tend to hold onto their losing trades in the hope that they will reverse and become profitable trades. These traders need to learn that holding onto losing trades will only make the losses larger in the long run. Eventually there will be a losing trade that does not reverse, and this one losing trade will then erase any profit that was made by holding the previous losing trades (this actually happened to a trader on the very day that I warned them about it).

Sentimental Trading Should Be Simulation Trading

If you are a sentimental trader, and are having difficulty overcoming your sentimental trading, try trading in simulation rather than trading live. By trading in simulation you will be able to practice letting go of your trades without reaping the consequences of any mistakes (i.e. without risking any real money). Once you have mastered the psychology of letting go of your trades, you should find it easier to switch to live trading without becoming sentimental about your trades again.

[Tom]

Scalping and Patience

Scalping is one of the trading styles (i.e. scalping, day, swing, and position trading) and is specifically the shortest tem trading style (i.e. scalping makes the trades that are active for the least amount of time), but in all other respects scalping is no different from the other trading styles.

One of the perceived differences between scalping and the longer term trading styles is the amount of time between trades. Scalping is often (and incorrectly) assumed to make many trades very quickly, but the reality is that scalping often requires waiting just as long as day trading, sometimes as long as swing trading, and theoretically even as long as position trading.

Scalping Myth

One of the reasons that new traders are often attracted to scalping is the popular belief that scalping makes many small trades in rapid succession, with very little time spent without an active trade. As a result, many new traders approach scalping with an expectation of making a lot of trades very quickly (not to mention the expectation of making a lot of profit very quickly), and consequently they perform their scalping incorrectly.

Scalping is the shortest term trading style, and therefore does tend to make smaller trades (i.e. trades with smaller targets and stop losses), but the frequency of the trades does not necessarily increase accordingly.

Scalping Requires Patience

Scalping therefore requires a lot more patience than many new traders expect or are prepared for. Scalping definitely requires as much patience as day trading, sometimes requires as much patience as swing trading, and in theory could require as much patience as position trading (i.e. waiting weeks for the next trade). Professional scalpers will wait as long as necessary for their next trade, even if that means waiting several days for a trade that then lasts only five minutes.

Any lack of trading when scalping can theoretically be offset by trading additional markets (e.g. where a day trader might trade a couple of markets, a scalper might trade several markets), as the additional markets could provide additional trades (assuming that the markets are different enough), but trading many markets is not a requirement of scalping, and there are some very successful (and very patient) professional scalpers who only trade a few markets.

[Jennifer]

Patience, Decisiveness, and Calmness

The idea of making a living as a day trader appeals to a large number of people, but not everybody has a personality suitable for day trading. Even people that are successful in other fields (even related fields), often find that they are not compatible with day trading. Day trading is a flexible profession (meaning that it can be adapted to suit different styles), but there are a few qualities that all day traders need to have in their personalities, in order to be successful (profitable), and avoid becoming a nervous wreck in the process.

Patience

When non traders imagine day traders, many people think of traders in a trading pit, wearing brightly colored jackets, shouting and waving their arms about. While this may have been true once, it is no longer an accurate image of day trading. Modern day trading is performed by sitting quietly in front of a computer, waiting anywhere from a few minutes, to several hours, or even days, for the next trade to come along. Being able to wait patiently is a necessity, otherwise you will find yourself taking trades that are not part of your trading system (known as making up a trade), and most likely losing money on them. Waiting patiently does not necessarily mean doing nothing, and there are many things that you can do while you are waiting for your next trade. Some day traders join live trading rooms where they can interact with other traders, some traders play computer games and watch movies, and many day traders eat their meals while they are trading (breakfast often coincides nicely with the market open).

Decisiveness

Deciding when to enter and exit trades is one of the most basic functions of a day trader, and it is important that these decisions are made as efficiently as possible. Being decisive is vital to successful day trading, otherwise you will only sit and watch trades that you should have actually taken. Being decisive does not mean being rash, and taking trades that you are not sure about, but it does mean acting promptly when a trade does come along. A common pitfall that many beginning day traders come across is seeing a trade occuring, but hesitating and waiting for the trade to start moving into profit before entering (waiting for confirmation that the trade is going to be a winning trade before they enter it). This always results in an entry price that is not as good as it would have been with a prompt entry, and can turn a winning trade into a losing trade.

Calmness

Remaining calm during trading is one of the most important personality traits for a day trader, but it is also one of the most difficult to obtain and practice. As humans, the natural reactions to a winning trade are excitement and joy, and the natural reactions to a losing trade are panic and sadness, but day traders need to control these emotions, otherwise they will adversely affect their trading decisions (particularly the negative emotions). For example, the panic that occurs after a losing trade might make you take a new trade almost immediately in an attempt to make the money back, even though there was no trade according to your trading system.

Trading in Simulation

Trading in simulation is a good way to practice your patience, decisiveness, and calmness during trading, without risking any real money. After many hours, days, or weeks of simulation, you will have a good idea of how your personality and your emotions will affect your day trading, but even then, there will still be an emotional response when you start trading live.

[Jennifer]

Scalping and Risk

Scalping is one of the trading styles (i.e. scalping, day, swing, and position trading) and is specifically the shortest tem trading style (i.e. scalping makes the trades that are active for the least amount of time), but in all other respects scalping is no different from the other trading styles.

One of the perceived differences between scalping and the longer term trading styles is the amount of risk that is required in order to make trades. Scalping is often (and incorrectly) assumed to have lower overall risk because its trades are only active for a short amount of time (e.g. trades are not held overnight, etc.), but the reality is that scalping requires just as much risk as day trading, swing trading, and even position trading (seriously, even position trading).

Scalping Myth

One of the reasons that new traders are often attracted to scalping is the popular belief that scalping trades are active for the shortest possible amount of time, and that scalping therefore has the lowest possible risk. As a result, many new traders approach scalping with an expectation that their trading will be very low risk (but with the potential for very high profit), and consequently they perform their scalping incorrectly (e.g. increasing their trade size, etc.).

Scalping is the shortest term trading style, and therefore does tend to make shorter term trades (i.e. trades that are active for the least amount of time), but the risk of the trades does not necessarily decrease accordingly.

Scalping, Day, Swing, and Position Trading Risk

Scalping, day trading, swing trading, and position trading all require the same amount of risk (at least from a time spent with an active trade perspective). The popular belief that making only short term trades lowers the overall risk of the trading because the trading is exposed to the movement of the market for the least possible amount of time is incorrect. Risk is not related to the amount of time that is spent with an active trade, and therefore scalping (where each trade might be active for a few minutes) has no lower risk than position trading (where each trade might be active for several months).

Professional scalpers know that the risk of their trading is not related to the amount of time that is spent with an active trade, and they will therefore keep their scalping trades active for as long as necessary, even if that means keeping a scalping trade active overnight.

[Jennifer]

Stress and Trading

Stress is one of the most common emotional problems that traders face, and trading while under stress can (read as will) have a significant impact on a trader's profit and loss. There are many different forms of stress, but for the purposes of this discussion, we will consider stress as being either trading stress (i.e. stress caused by trading) or external stress (i.e. stress from non trading sources).

Trading Stress

Trading stress is stress that is caused by the act of trading. For example, the fear of losing money can place a trader under significant stress. Perversely, trading stress only compounds the original problem. For example, if a trader is having difficulty making a trade management decision, the stress that ensues will only make it harder to make the decision, and will almost guarantee that the decision is made badly.

The solution to trading stress is knowledge and experience. Knowledge gives a trader the ability to trade well, and experience gives a trader the confidence to trust in their knowledge. When a trader knows that they have the ability to be profitable, and they also have the confidence to believe in themselves, it is much easier to overcome any stressful situations that might arise.

External Stress

External stress is stress that comes from any source other than trading. For example, a trader might be having relationship problems with their husband or wife (which happens more often than you might think due to the solitary nature of trading). External stress is the most difficult type of stress to avoid, because its cause is often out of the trader's control.

The solution to most external stress (at least from a trading perspective) is to temporarily trade in simulation instead of trading live. Trading in simulation during stressful times allows a trader to continue trading, but without risking any real money. Once the stressful situation has been resolved, the trader can go back to trading live without having to make up any stress related losses.

How Stress Affects Profit and Loss

Stress affects a trader's profit and loss in a number of different ways, and the exact manifestation will be different for each trader. For some traders, stress might cause them to trade more than usual (perhaps in a desperate attempt to make more money), while for other traders, stress might cause them to trade less than usual (perhaps because they are unable to make any decisions). However the stress is realized, the result will always be a negative impact on the trader's profit and loss. So if you suddenly find yourself trading badly, consider your emotional state and whether that might be the cause, before you decide to make any adjustments to your trading (e.g. changing your trading system, etc.).

[Tom]

Trading and Intuition

I was once asked by a trader how they could determine if a market was moving decisively (i.e. was moving in a single direction), and my answer was that if they were not sure, then the market was not moving decisively. In other words, if they looked at a chart and they didn't immediately know which direction the market is moving, then it was not moving in a single direction.

Intuition and Instincts

I was suggesting to the trader that they use their intuition and instincts in deciding if the market was moving as they required, rather than a fixed measurement (e.g. an indicator being above or below a particular level). Intuition and instincts either play an important role in trading, or they play no role at all. This is because they apply differently to discretionary and system trading.

Discretionary Trading

Discretionary traders can (and very often do) use their intuition to confirm (or negate) their trading decisions. For example, a trader might decide not to make a trade because the trade would require a slightly larger stop loss than usual, even though all of their entry requirements had been met.

While discretionary traders are able to use their intuition and instincts in their trading, they need to make sure that they do not confuse them with fear and greed. For example, whenever a trader decides not to enter a trade based upon their intuition or instincts, they need to know why they are doing do, otherwise it is possible that the decision is based upon fear of a losing trade. Similary, if a trader decides to hold a trade longer than usual, they need to make sure that it is their intuition rather than greed that is making the decision.

Knowing the difference between intuition and emotions is something that will come with experience. In the meantime, if you are making a trading decision and you find that your heart is racing or that you are starting to sweat, you are probably making an emotional rather than an intuitive decision.

System Trading

System traders on the other hand, cannot use their intuition in their decision making process. System traders make their trading decisions during their testing and analysis of their trading system, rather than during live trading. If a system trader starts using their intuition and instincts to modify their trading decisions, they are no longer a system trader, and they may need to modify other aspects of their trading accordingly (i.e. there is no such thing as a part discretionary and part system trader).

[Tom]

The Trading Psychology of the Days of the week

Many new traders start trading with real trading capital (i.e. making trades that place real money at risk, as opposed to make trades in simulation) before they are ready to do so (e.g. before they have learned trading correctly, using an incorrect trading technique or trading system, etc.), and by the time that they realize their mistake, it is too late for them to do anything about it.

Knowing whether you are ready to start trading with real trading capital or not is extremely difficult (and almost impossible for new traders) because of the psychology and emtional aspects that are involved (e.g. being under pressure to make money, needing to bolster a lagging self-esteem, etc.), but there is a rather odd method of determining whether you are ready to make trades with real capital or not that uses the psychology of the days of the week.

Monday Morning

How you feel when you wake up Monday morning is an excellent indicator (no, not a technical indicator) of whether you are ready to make trades with real trading capital or not.

If you wake up feeling content, perhaps somewhat excited, and looking forward to the day (particularly to when your markets will open for the day), then you could very well be ready to make trades with real trading capital. If on the other hand, you wake up feeling nervous, trying to think of an excuse for not getting out of bed, perhaps with a feeling of dread for what the day holds, then you are very likely not ready to make trades with real trading capital.

Your emotional condition on Monday morning is a very reliable indicator of how you really feel about your trading, not how you think you feel about your trading, and not how you want to feel about your trading. New traders often wake up on Monday morning with negative emotions (even if they do not directly attribute the emotions to their trading), whereas professional traders usually wake up feeling calm, and with a sense of pleasant anticipation for the day's trading.

Friday Evening

How you feel on Friday evening (particularly at the moment when your markets are closing for the week) is equally as useful as how you feel on Monday morning, but usually in the opposite direction.

If on Friday evening, you feel the stress lifting off of your shoulders, and you breathe a large sigh of relief, you have probably not really enjoyed the previous week, and are most likely not ready to be making trades using real trading capital. If on the other hand, you wonder what you are going to do over the weekend, and breathe a sigh of relief that Monday morning is only two days away, then you are most likely ready to make trades using real trading capital.

Your emotional condition on Friday evening is an equally reliable indicator of how you really feel about your trading, not how you think you feel about your trading, and not how you want to feel about your trading. New traders often feel a sense of relief that they have two whole days without any trading, and try to convince themselves that they will spend the entire weekend analysing their charts to determine what went wrong the previous week. Professional traders usually smile, and then either check the timetables for their weekend skiiing trip, or (if they more philosophically inclined) wonder if their charting software is sad that it won't be used for the next two days.

The Exception to the Above

While the psychology of Monday morning and Friday evening is extremely reliable, there is an exception that could negate the entire idea. If there is something else in your life that is more significant than your trading, and that could cause more pronounced emotions (such as your best friend having being run over by a bus yesterday afternoon), then your emotional condition at any given time may not be related to your trading at all. If on the other hand, the only other emotionally significant event that is occurring in your life is that you forgot to program your coffee maker the night before, then your emotional condition on Monday morning and Friday evening is most likely related to your trading.

The Solution

If you are one of the new traders who is on the wrong side of the psychology of the days of the week, the solution is very very simple, and is to learn trading correctly. Learning trading correctly will provide the knowledge, and allow you to gain the experience, that will enable you to move to the correct side of the psychology of the days of the week.