Articles on Psychology of Trading

[Yousuf Ali]

The first thing you must do in order to conquer the psychological aspects of trading is to know what makes you tick and what your trading personality is. What is your tolerance to risk and what do you need to do to ensure you make the correct trading decisions?

You find it hard to tolerate big intraday swings you may wish to try swing trading instead of day trading. If you find your emotions causing you to frequently change your mind about your trading decisions, then you could consider developing a system.

In the same way, it is always possible to improve your mindset, so think about keeping a diary or trading journal detailing your trade rationale and your emotions at the time of each trade. Continually re-evaluate your diary so that you can see where you are going wrong and how you can overcome your limitations

[Jennifer]

Why Markets Fall Quicker Than They Rise

All markets move in both directions (up and down), and as professional traders, we do not care which direction the markets are currently moving, because we can make a profit by trading in either direction (long or short). However, there is one difference between the two directions that is interesting to professional traders.

The difference is that most markets tend to move down quicker than they move up. This applies to all types of markets (stock indicies, futures, individual stocks, currencies, etc.), and to all timeframes (fifteen minutes, hourly, daily, etc.). The reasons for this tendency are the human emotions that are associated with rising and falling markets.

Fear and Greed

The non trading public (which includes most buy and hold investors) have been conditioned to believe that rising markets are good and falling markets are bad. When the markets are going up, the emotion of greed is in control, so the public buy stocks, which gives the markets short term momentum to the long side. When the markets are going down, the emotion of fear is in control, so the public sell their stocks, which gives the markets momentum to the short side. Initially, these two emotions would appear to balance each other, however, fear is a much stronger emotion than greed, so the reaction to the fear is much greater than the reaction to the greed. It is this reaction to the fear that propels the markets downwards.

For example, long term investors hear some news about company XYZ, so over several days they buy shares of XYZ at various prices that they consider reasonable. This slow accumulation of XYZ causes its stock price to increase, so the long term investors hold the stock thinking that the upward price movement will continue (the emotion of greed is in control). However, once all of the long term investors have bought XYZ, there is no further upward pressure, so the stock levels off and then starts to decline. The long term investors now see their profits disappearing, so they all sell their shares at any available price (the then current market prices) in an attempt to keep some of their profit (the emotion of fear is now in control). As the panic selling happens in a shorter time span than the buying, the price of XYZ falls quicker than it rose.

Professional Traders


Professional day traders experience the same emotions (fear and greed), but hopefully they have learned to keep their emotions under control, so they do not react the same way (this is easier said than done by the way). Professional traders will follow their trading system regardless of what emotions they are experiencing, and this allows them to consistently make a profit in market conditions that amateur traders lose money in.

Professional traders also know about the fear and greed cycle that the public experiences, and they will trade to take advantage of this. Continuing the above example, when the professional traders hear the same news about XYZ, they may wait a few days, and then take the opposite trade (i.e. a short trade). The professionals' selling also adds momentum to the stock's decline, thereby increasing the speed at which the price falls.

[Jennifer]

Reacting to an Unprofitable Trade

One of the things that all traders (new traders, amateur traders, and professional traders) have in common is that they are going to experience an unprofitable trade from time to time. As one might expect, new traders and amateur traders tend to experience unprofitable trades more often than professional traders do, but that is not the main difference between the different groups of traders. The main difference between new traders, amateur traders, and professional traders when confronted with an unprofitable trade, is the trader's reaction to the unprofitable trade.

New Traders

When new traders experience an unprofitable trade (e.g. a trade that reaches its stop loss), they usually think that they have done something wrong, and they immediately starting looking for a way that they could have modified their trading system or trading technique to avoid the unprofitable trade (e.g. they should have been using a two minute chart instead of a one minute chart).

Amateur Traders

When amateur traders experience an unprofitable trade, they usually get angry or upset, and start looking for someone to blame for their trade being unprofitable (e.g. a larger trader was looking for their stop loss, etc.).

Professional Traders

Professional traders on the other hand, usually say something like "Hmm, that is very interesting", or "Hmm, I didn't expect that to happen", or perhaps "Hmm, what shall I have for dinner this evening?", while they calmly review their charts to see where their next trade will now occur.

One other difference between the way that new traders, amateur traders, and professional traders react to an unprofitable trade, is that professional traders usually know why the trade was unprofitable (i.e. why the market continued moving in the opposite direction to their trade, and why the market moved to the price that it moved to).

Learn From Your Reaction

Regardless of which group of traders you think that you are in, your reaction to an unprofitable trade will tell you the truth about which group of traders you are in. For example, you might think that you are a professional trader, but if you react to an unprofitable trade with anger, then you are not a professional trader, but are probably an amateur trader who is trading incorrectly (e.g. using one of those well advertised, 100% guaranteed trading systems, that for some reason only makes long trades), but doesn't want to admit it.

[Yousuf Ali]

Positive Thinking

Stay positive, always remind yourself why it is you are trading and remember to keep your goals in sight. Make sure to visualize yourself reaching those goals and keep up a positive internal dialogue as often as you can.

[Tom]

Moving from Simulation Trading to Live Trading

Most new day traders start trading in simulation so that they can gain experience without risking any real money. Once they are consistently profitable in simulation they will move to live trading, and this is when they come across one of the most common problems that affect new day traders. Moving from simulation trading to live trading sounds like an easy task, but many traders find that what was once a profitable trading system immediately starts losing money when it is traded live.

Fear of Losing Money

The reason that their trading system suddenly stops working is the additional emotion that comes with trading their own real money. The fear of losing one's own money is a very strong emotion, and can cause even experienced traders to make mistakes. Hesitating before entering a trade, moving their stop loss to break even too early, or taking a smaller profit than they would normally, are all common mistakes that are made because of the emotion of fear. This situation often gets compounded, because many new traders are unable to determine what they are doing differently, and are therefore unable to fix the problem.

Overcoming the Fear

If you are experiencing this, the solution is to have faith in your trading system. If you have tested your trading system thoroughly, and it consistently makes a profit, then you need to have faith in your trading system, and follow it exactly.

The following steps will help you determine what you are doing differently when you are trading live (entering late, moving your stop loss, etc.).

Keep a record of every trade that you make, including the entry, the target and stop loss settings, any changes that are made (such as trailing the stop loss), and the exit.
At the end of the day (or week), go back over the trades in simulation and compare the simulated trades to your trading log.
If there are any differences between the simulated trades and the live trades, it should be easy to see where (and hopefully why) the differences are occurring.

[Tom]

How Percentages Describe Financial Market Price Movement

The price movement of financial markets (e.g. stock indices, individual stocks, currencies, commodities, etc.) is often described using percentages (e.g. fifty percent, 50%, etc.). For example, if the price of an individual stock market moves from $50 to $55 dollars, the stock market could be said to have moved upwards (i.e. increased) by ten percent.

While there is nothing wrong with describing financial market price movement using percentages, it can be useful to know that percentages do not necessarily describe the price movement equally, and that percentages can be biased to make it seem as though a financial market is increasing in value when it is not really doing so.

Percentage Basics

A percentage describes the value of a financial market (or an amount of anything for that matter) as an amount relative to the previous value of the financial market. For example, if an individual stock market has a value of $80, then one percent would be equal to $0.80 (calculated as 80 / 100 = 0.8), ten percent would be equal to $8 (calculated as (80 / 100) * 10 = 8 or as 80 / 10 = 8), and so on.

The Appearance of Percentages

If an individual stock market had a value of $80, and the price of the individual stock market moved upwards by $8, then the individual stock market would be said to have increased in value by ten percent. Similarly but conversely, if an individual stock market had a value of $80, and the price of the individual stock market moved downwards by $8, then the individual stock market would be said to have decreased in value by ten percent.

Given no further information (such as the individual stock market's previous price movement), it appears as though describing the individual stock market's price movement using percentages is exactly correct (which it is), and that describing the individual stock market's price movement using percentages is equally balanced between the value of the individual stock market increasing and the value of the individual stock market decreasing.

The Reality of percentages

If an individual stock market had an initial value of $80, and the price of the individual stock market moved upwards by $8, then the individual stock market would be said to have increased in value by ten percent (there is nothing different so far). However, if the price of the same individual stock market then moved downwards by $ $8 (back to its original value of $80), then the individual stock market would be said to have decreased in value by nine percent (one percent less than the previous increase of ten percent).

In other words, when the price of the individual stock market moved upwards by $8, the increase in value as a percentage was ten percent, but when the price of the individual stock market moved downwards by the same $8 (i.e. exactly the same monetary value), the decrease in value as a percentage was only nine percent.

The same difference applies to any monetary value, and becomes more pronounced as the monetary value (or the percentage) increases. For example, if a stock index had an initial value of $1,000, and the price of the stock index moved upwards to $2,000, then the stock index would be said to have increased by one hundred percent (100%), but if the price of the same stock index then moved downwards to $1,000 (i.e. back to the original price), then the stock index would be said to have decreased by only fifty percent (50%), even though the monetary amount (i.e. the $1,000) is exactly the same.

Using percentages to describe the price movement of a financial market is correct, but in doing so, it can appear as though financial markets move upwards more than they move downwards (particularly if the previous price movement of the financial market is not provided).

[Jennifer]

Fear and Greed

In order to be a successful day trader, you need to have the right tools, choose the right markets, and trade the right trading systems. However, it is just as important to have the right psychological and emotional outlook. Without the right psychology, your emotions will have a big impact on your trading, and may even prevent you from trading at all. The two main emotions that day traders experience are fear and greed, and while you will probably not be able to remove these emotions completely, you will need to manage them.
Fear
Fear is the emotion that stops us from doing things that might be too risky. In the right quantity, fear is obviously an emotion that we need, but when fear becomes too great we can be prevented from doing things that might be necessary. In day trading, the main fear a trader has is that they are going to make a losing trade and lose money. This is a rational fear as no trader wants to lose money, but it is irrational if it prevents the trader from taking any trades in the first place. As an example, a trader might make a losing trade, and then be too fearful to make the next trade, which of course turns out to be a winning trade, and would have covered the previous loss. By letting the fear take control, the trader now has a net loss, even though a winning trade was available. The emotion of fear can be overcome by acknowledging that all day traders have losing trades occasionally, but as long as they are less frequent than the winning trades, there is nothing to be afraid of as there will still be a net profit.
Greed
Greed is the opposite emotion to fear, in that it is the emotion that makes us do things we would not normally do. The right amount of greed is necessary because it gives us the motivation to work at something, but when we are too greedy we will start doing things even when we know that we should not. In day trading, greed can make traders make random trades, or hold on to positions longer than their trading system dictates. For example, if a trader is watching a market moving strongly upwards, the trader might be tempted to make a trade even though their trading system says not to. The trader has allowed the greed to take control, and more often than not in this scenario, they will be buying right at the end of the move and will have a losing trade. The emotion of greed can be overcome by testing and then trusting in your trading system, and knowing that if you follow it correctly, it will make a profit without taking every potential trade.

[Jennifer]

Avoiding Trading Noise

One of the hardest things to learn to cope with in day trading is the phenomenon often referred to as "noise." Frustrating to deal with whether you're seasoned or new to day trading, beyond being a nuisance, trading noise often creates whipsaw losses for those who fail to recognize and deal with it correctly.
Trading Noise Defined
No matter the instrument traded, be it stocks, futures, options, ETFs, etc., and notwithstanding opening gaps, most trading sessions tend to be filled with tedious back-and-forth activity, much like a rugby scrum or a grudge match. Borrowing from the maxim used to describe police work, trading is best characterized as long periods of boredom and monotony interrupted by extreme periods of excitement. The noise is the lackluster activity that tends to dominate, broken up by occasional periods of extreme excitement - often short-lived - where the price of the instrument will move in earnest, driven by true conviction exhibited by one side or the other.
Churned and Burned
The problem presented by trading noise is the fact it doesn't come labeled as such. Moves in either direction look real and leave one with the impression that a trend is underway, be it new, a continuation of an existing trend after a period of consolidation or as a reversal.
The differentiating factor between noise and real moves is conviction. Simply put, real moves are backed by real dollars and go somewhere in an organized fashion - they tend to push the trading instrument to a new level (often several levels) either above or below the previous level.
Trading noise is unorganized and generally does little more than push the bounds of the current range, triggering trade signals and tempting unaware traders into positions, while the move itself breaks down and teeters out or actually reverses course. More often than not, this pattern of disorganized activity will play out numerous times during the course of any trading session, causing inexperienced traders to over-trade and churn their accounts. Entering and exiting losing positions at or near the same levels on multiple occasions during a single session is a hallmark signal of a trader that has succumb to trading noise.
Real Activity Versus Noise
The key to effectively dealing with trading noise is to first recognize that it occurs during most trading sessions. A good example is the so-called institutional lunch, which in truth is the period of time between the morning session - the first couple hours of the cash or pit session - and the final couple hours leading into the pit or cash-session close. Generally speaking the institutional order flow and overall volume tend to slow during the middle portion of the daily trade session. Lacking true dollars to push moves through with conviction, lunch period activity is notorious for whipsawing traders.
Moreover, it's important to understand that there are generally few organized, tradable moves during any given trading session. Some sessions are devoid of real trading moves altogether, while most will offer one to as many as a couple real moves.
Smart traders come to recognize that whether they catch or miss such a move, especially early on, the odds are greatly diminished they'll have another opportunity as the session plays out - the news and events driving the session are generally baked into the early part of trade day. Good traders play the probabilities and are cautious about being drawn into additional trade setups, understanding that most activity will likely be false - nothing more than trading noise.
How Do You Avoid It?
Discipline is critical when it comes to avoiding whipsaw and the resulting overtrading activity synonymous with trading noise. Moves are real or they are not - a good trading system will help identify and capture genuine opportunities. All else is noise and should be avoided to the extent possible. Understanding probabilities and the limited nature of opportunities available each day is critical knowledge that should be factored into all trade decisions.
The best defense against trading noise is that of adhering to a solid trading plan that includes strict rules limiting the number of daily trades to be taken and covering daily/weekly drawdown limits. Those rules will keep a trader from churning their trade deck.
Bottom line, a good plan implemented in a disciplined fashion will experience more gains than losses over time, but there will always be days, sometimes even weeks or longer periods, where the trading ranges are tight and the overall opportunities are limited. Trading smart and adhering to the rules during such occasions enables a trader to live through each session and trade another day.

[Jennifer]

What is Day Trading?
Day trading (and trading in general) is the buying and selling of various financial instruments, such as futures, options, currencies, and stocks, with the goal of making a profit from the difference between the buying price and the selling price. Day trading differs slightly from other styles of trading in that positions are rarely (if ever) held overnight or when the market being traded is closed.
Day trading was originally only available to financial companies (such as banks), because only they had access to the exchanges and market data. But with recent technology such as the Internet, individual traders now have direct access to the same exchanges and market data, and can make the same trades at very low cost.
Trading Styles
There are several different styles of day trading, suited to different day trader personalities. The styles range from short term trading such as scalping where positions are only held for a few seconds or minutes, to longer term swing and position trading where a position may be held throughout the trading day. Most day trading systems have a lot of flexibility, and can have open positions for anywhere from a few minutes to a few hours, depending upon how the trade is doing (whether it is in profit). Some day traders will trade multiple styles, but most traders will choose a single style and only take that type of trade.
Day trading also has different types of trade, such as trend trades, counter-trend trades, and ranging trades. Trend trades are trades in the direction of the current price movement (i.e. buying if the price is moving up), and counter-trend trades are trades against the direction of the current price movement (i.e. selling if the price is moving up). Ranging trades are trades that go back and forth between two prices, and are used when the market is moving sideways. Most day traders will choose a single type of trade, but some traders will take different types, and choose which one to trade depending upon the current condition of the market.
In addition to the style and type of day trading, there are other variances between day traders. Some day traders like to make many trades throughout the trading day, while others prefer to wait for what they consider the best conditions for their trade, and perhaps only make one trade per day. However many trades are made, the trading process that is used, and the desired goal of making a profit, are the same.
Markets
There are many different financial instruments, or markets, that can be day traded, and they are offered by various exchanges throughout the world. The main types of day trading markets are futures, options, currencies, and stock markets. Within these types, there are groups of markets based on stock indexes (such as the Dow Jones, and the DAX), currency exchange rates (such as the Euro to US Dollar exchange rate), and commodities (such as gold, and oil). Day traders can have access to all of the exchanges and their markets via direct access brokers, so called because they offer direct access to the exchange, which provides faster trade execution at lower cost. Further information about the available markets can be found in the article Which Markets can be Day Traded?, and details of the most popular day trading markets are available in the Market Profiles category.

[abih]

Our biggest enemy on trading forex is our self. till now, I am still struggling to control my own emotion. I hope I can learn a lot from this thread to control it.