Articles on Psychology of Trading

[Jennifer]

Hi Friends,

I am opening this thread to post some important Articles on Psychology of Trading. I request you all to share more informative articles on this thread. Psychology plays an important role in our day to day activities and in the case of Trading, its much more evident. To succeed in Trading, the Trader should be psychologically and emotionally very strong and the more we understand about it the more better it is. To begin with, I am sharing a nice article on Psychology of Trading with you all, please keep this thread populated with many more articles.



Trading Psychology

The psychological state of the crowd and the psychological state of the investor or trader are important areas to look at when considering an investment or trade. Bubbles and crashes within any market arise out of crowd psychology. Bubbles and crashes in any one individual account also arise out of the psychological state the single person brings to both their decision and their execution of their decision.

What do we mean by psychological state? Answer: The combination and type of intellectual, physical and emotional energy coming to bear upon an investment or trading decision. Put another way - trading psychology is the sum total influence of a human psyche on the process of making an investment or trading decision. The American Heritage dictionary defines psyche as: "The mind functioning as the center of thought, emotion, and behavior and consciously or unconsciously adjusting or mediating the body's responses to the social and physical environment."

Fear and Greed

Typically when people talk about psychology in the markets they reduce it to the emotions of fear and greed. Likewise, the typical response is to try to avoid the influence of the feelings of fear or greed. In many ways, this is a futile effort in that those emotional responses are natural and are not going to go away. A better approach is to accept that reality and learn how to become aware of their influence on a decision and also aware of their influence on how a stock might be acting.

Emotional Awareness in Investing

In actuality, the situation is much more complex and nuanced than that and the work being done in trading psychology now is extending and applying the work of neuroscience in understanding the human response to a risk reward decision. Researchers such as Dr. Andrew Lo of MIT, Dr. Brian Knutson of Stanford and Camelia Kuhnen of Northwestern are delivering excellent work which illuminates just exactly what the brain is doing when faced with a choice about risk.

There is great evidence for the value of actually including emotional intelligence in making decisions about the financial markets. This is an area that is just beginning to be explored. It also extends to the interaction between human and computer in the situation where trading strategies are driven by quantitative models which drive automatic trade executions in the market.

How Can an Investor Account for Psychology?

Two simple ways to address this ever-present issue are to always ask the following two questions. #1)Is my analysis being impacted by what the crowd is doing? #2) Is my analysis being colored by the result of my last investment or trade? Including an analysis of the the human factors influencing a trading decision offers to opportunity to reduce risk and improve return.

[Tom]

Hi Jennifer,

Where have you been these days? Thanks for starting a good thread and I agree with your views on Trading Psychology... will keep posting interesting articles on this thread.

[Jennifer]

Hi Friends, here is another great article related to this thread topic.


Rethinking Trading Psychology


Conventional wisdom in trading psychology used to depend on two primary tenets – discipline and "control your emotions."

But that was before neuroscience started putting traders, poker players and other risk-gamers into brain scanners.

Now that we know that all decisions depend on the presence of an emotion, most perception occurs outside of our awareness and that how our bodies feel will influence what we think, Trading Psychology 101 requires a re-write.

Did you know that research indicates we can only make a few – maybe as little as two – “disciplined” decisions in a row?

Researchers call this decision fatigue or ego-depletion. For traders, it means that instead of sitting at the screen fighting for every tick that that same quantity of discipline imbued into a structured plan for getting out of the office and away from the quotes will most likely produce an increase in P&L.

Research also shows that complex decisions, or those with many conflicting data points, create the most satisfying results when they are made non-deliberately. This means that letting a trader’s unconscious – or all of his or her accumulated knowledge – percolate or bake into the realization the trading brain has delivered the decision equivalent of superb coffee or heavenly brownies.

In other words, going to the gym not only in the middle of the day but even in the middle of a trade will optimize your trading psyche to make the most profitable judgment call on a trade’s exit point. Pumping iron or spinning those bike wheels turns what we used to call physical energy into market-reading clarity. In fact, it is likely that your better read on the market’s next dance will seemingly magically come to you when your earbuds have your favorite song beating and not when you are staring at every tick trying to force the screen to give up the future’s secrets.

Which brings us to the inexorable connection between the body, feelings, emotions and risk decisions: the maxim “control your emotions” emanates from a misunderstanding. Any of us can feel anything – and not act on. We do that all the time. Logically we only have to control our actions. Senses, feelings and emotions should be considered data and analyzed.

Adopting the strategy of “emotions as information” leads to two primary benefits – knowing the difference between and impulsive feeling and an intuitive (market experience) one. And second, disengaging repetitive emotions and events fueled from our past and acting in a fractal manner from our expectation of what the market is doing. We all bring our personalities to our perceptions. A large part of those personalities contain our characteristic reactions – the market is out to get me, I will all snatch defeat from the jaws of victory, the price action (authority figures) can’t be trusted and on we could go.

Antonio Damasio and his team got it started with the research reported in Descartes Error but now the proof is in, every decision includes emotion. This means every trading decision that turns out to be regrettable can be analyzed not from what went wrong with the analysis but from what feeling or emotion was really driving it. Everyone can look for FOMO or fear of missing out or what is really fear of future regret. Decision theory indicates this feeling to be maybe the most powerful one we have.

To take another example of unconscious emotions and how the concept of fractal applies not only to price but to perception, say a trader has a tendency to fight the trend, most of the time this can be traced to a wholly unrelated mental context of needing to prove how smart they are, needing to buck authority or being stuck in feeling like a victim who missed the real move. Untangling emotional data (versus ignoring it) gives a trader the opportunity not only to be making judgment calls on the here and now but opens up their whole perceptual and judgment toolbox to see and act on the fundamental question, what are most of the other market participants about to do.

Given that most traders try to predict market movements based on numbers alone, the trader who wraps the human question around the numbers while simultaneously adopting what decision science now knows about risk perception and judgment automatically derives a calculable advantage.

[Jennifer]

hi Tom, where is the article that you promised to post

[Tom]

hi Jennifer, please forgive my forgetfulness, here is a nice article related to this thread.

Logic: The Antidote To Emotional Investing

Much has been written about crowd and group behavior in the investment industry, but one aspect that has received little attention is emotional contagion. As the term suggests, people can infect each other behaviorally. And in the field of investment, this can cost everyone a lot of money.

The term contagion has a negative connotation from its customarily application in the field of medicine and disease. Still, the term is very apt in the context of investment, because contagion frequently leads to irrational or imprudent behavior. It prevents "healthy" evaluations of investment opportunities, and gets in the way of sound judgment in decision-making.

Contagion leads to the classic blunders associated with following the crowd - buying into the market when prices are high, and fleeing in panic when they drop. Contrarian behavior, generally the best (or even, arguably, the only) way to really make money, is, by definition, undermined by emotional contagion.

How Does Contagion Infect the Investor's Mind?

As an example, let's assume that Ivan leads a placid life, earning a good living and putting his money into a secure retirement fund that does ok, but does not "shoot out the lights." Some of his friends are investing money in foreign bonds, and making double the return that Ivan receives from his conservative fund. Ivan's resistance is strong at this point, and he follows his gut feeling that these bonds are too risky.

However, out of a mixture of curiosity and envy, Ivan the investor starts asking his friends how well the bonds are doing. They tell him that the returns are excellent, and are sure to stay that way. Ivan's resistance slowly weakens, as he hears repeatedly how much he is losing out on and eventually, he gives in, buying bonds when they are nearing their peak.

Soon afterwards, some crisis occurs overseas, and his friends start to panic - as do many other investors. Once again, Ivan is contaminated and thinks he should also sell out before it is too late. After all, that is what his friends are doing.

Two months later, when the price is half of what it was when Ivan bought in, he is disillusioned and still recovering from his losses. Under normal circumstances, this would be the ideal time to make an initial investment, to get back in to the market or to top up existing holdings, but the emotions of contagion always work in the wrong direction, and Ivan retreats to recover.

Subconscious Contagion

Emotional contagion is relatively automatic, and inevitably entails the suppression of conventional rationality and caution. In the investment industry, the heady mixture of media reports of money to be made, and seeing others capitalize without much effort, leads to emotional pressure to charge ahead and share in the gains. It is very tempting to go into an investment that is doing strikingly well, and people tend to suppress any warnings of overheating or information to the contrary.

Downward Pressure Is More Powerful Than Upward

Negative events tend to elicit stronger and quicker emotional, behavioral and cognitive responses than positive events. Hence, when markets and investments go sour, the contagion of panic is even worse than the pressure to buy when markets are booming and overheated. This explains why investments can lose their value so fast. The sheer blind panic, as people desperately try to avoid losses, is an irresistible and disastrous force.

Why Is Emotional Contagion Common?

On the one level, people tend to imitate those who seem to be successful. Envy and greed invariably attract others into the same activities. Evolutionists have another explanation, as well. In some instances, emotions help people to adapt to the circumstances, and contagion can thus aid survival. For instance, if people see others work hard to earn a living and the results are there to be seen, the mimicry is a purely positive reaction.

Similarly, where there is danger of fire, for instance, if the emotional contagion leads to precautionary measures being taken in order to prevent fires, the positive aspects are obvious. But if people only react when the town is already on fire, and trample each other to death in a belated attempt to escape, the contagion is too late and only exacerbates the loss of life and limb. This is exactly what tends to happen in investment markets. By the time contagion sets in and most ordinary people buy, it is too late in the cycle to make money. Prices and the risks of a crash are too high by that stage.

In other words, contagion is a natural emotional process that can be advantageous. But in the investment industry, it is frequently the exact opposite. Over-the-top emotions lead people to charge into investments at precisely the time when they should be getting out of them and into something on the ground floor.

Solutions

Emotional neutrality is the key. Only invest for coldly rational reasons, and never because other people are buying in droves and making money right now. Heated emotions, euphoria, excitement and similar sentiments are the enemy of prudent and profitable investing. Make sure that you do not get carried away with the crowd. In fact, it is generally best to do the diametrical opposite. When the crowd is cheering, leering and buying, look to sell; when it is moaning, groaning, panicking and selling, it is generally time to make your move.

Having a good, neutral advisor is a great help. Before taking the plunge - either in or out - ask informed friends or brokers who can be trusted for their advice. Objective third parties are invaluable in ensuring that you don't get carried away or become imprudent in the face of peer pressure and temptingly high, but unreliable and unstable, returns. Indeed, if you have a broker, his or her job - either ethically or even legally - is to ensure that you never join the proverbial queue of lemmings at the edge of a cliff.

The Bottom Line

Not only your body, but also your mind, is susceptible to infection. If you get constantly bombarded with reports of spectacular returns that seem destined to continue, the temptation may eventually become irresistible. Such investments are, all too often, has-beens that are approaching or are even past their peak, and are now risk-laden and likely to plummet.
Emotional contagion may lead the unwary or self-deluding into such disasters in the making. Get inoculated by neutral third parties, or simply make sure that you are not investing only because the euphoric masses are pushing up market values to unsustainable levels.

[Jennifer]

The Importance Of Trading Psychology And Discipline

There are many characteristics and skills required by traders in order for them to be successful in the financial markets. The ability to understand the inner workings of a company, its fundamentals and the ability to determine the direction of the trend are a few of the key traits needed, but not one of these is as important as the ability to contain emotions and maintain discipline.

Trading Psychology
The psychological aspect of trading is extremely important, and the reason for that is fairly simple: A trader is often darting in and out of stocks on short notice, and is forced to make quick decisions. To accomplish this, they need a certain presence of mind. They also, by extension, need discipline, so that they stick with previously established trading plans and know when to book profits and losses. Emotions simply can't get in the way.

Understanding Fear
When a trader's screen is pulsating red (a sign that stocks are down) and bad news comes about a certain stock or the general market, it's not uncommon for the trader to get scared. When this happens, they may overreact and feel compelled to liquidate their holdings and go to cash or to refrain from taking any risks. Now, if they do that they may avoid certain losses - but they also will miss out on the gains.
Traders need to understand what fear is - simply a natural reaction to what they perceive as a threat (in this case perhaps to their profit or money-making potential). Quantifying the fear might help. Or that they may be able to better deal with fear by pondering what they are afraid of, and why they are afraid of it.

Also, by pondering this issue ahead of time and knowing how they may instinctively react to or perceive certain things, a trader can hope to isolate and identify those feelings during a trading session, and then try to focus on moving past the emotion. Of course this may not be easy, and may take practice, but it's necessary to the health of an investor's portfolio.

Greed Is Your Worst Enemy
There's an old saying on Wall Street that "pigs get slaughtered." This greed in investors causes them to hang on to winning positions too long, trying to get every last tick. This trait can be devastating to returns because the trader is always running the risk of getting whipsawed or blown out of a position.
Greed is not easy to overcome. That's because within many of us there seems to be an instinct to always try to do better, to try to get just a little more. A trader should recognize this instinct if it is present, and develop trade plans based upon rational business decisions, not on what amounts to an emotional whim or potentially harmful instinct.

The Importance of Trading Rules
To get their heads in the right place before they feel the emotional or psychological crunch, investors can look at creating trading rules ahead of time. Traders can establish limits where they lay out guidelines based on their risk-reward relationship for when they will exit a trade - regardless of emotions. For example, if a stock is trading at $10/share, the trader might choose to get out at $10.25, or at $9.75 to put a stop loss or stop limit in and bail.

Of course, establishing price targets might not be the only rule. For example, the trader might say if certain news, such as specific positive or negative earnings or macroeconomic news, comes out, then he or she will buy (or sell) a security. Also, if it becomes apparent that a large buyer or seller enters the market, the trader might want to get out.
Traders might also consider setting limits on the amount they win or lose in a day. In other words, if they reap an $X profit, they're done for the day, or if they lose $Y they fold up their tent and go home. This works for investors because sometimes it is better to just "go on take the money and run," like the old Steve Miller song suggests even when those two birds in the tree look better than the one in your hand.

Creating a Trading Plan
Traders should try to learn about their area of interest as much as possible. For example, if the trader deals heavily and is interested in telecommunications stocks, it makes sense for him or her to become knowledgeable about that business. Similarly, if he or she trades heavily in energy stocks, it's fairly logical to want to become well versed in that arena.
To do this, start by formulating a plan to educate yourself. If possible, go to trading seminars and attend sell-side conferences. Also, it makes sense to plan out and devote as much time as possible to the research process. That means studying charts, speaking with management (if applicable), reading trade journals or doing other background work (such as macroeconomic analysis or industry analysis) so that when the trading session starts the trader is up to speed. A wealth of knowledge could help the trader overcome fear issues in itself, so it's a handy tool.

In addition, it's important that the trader consider experimenting with new things from time to time. For example, consider using options to mitigate risk, or set stop losses at a different place. One of the best ways a trader can learn is by experimenting - within reason. This experience may also help reduce emotional influences.

Finally, traders should periodically review and assess their performance. This means not only should they review their returns and their individual positions, but also how they prepared for a trading session, how up-to-date they are on the markets and how they're progressing in terms of ongoing education, among other things. This periodic assessment can help the trader correct mistakes, which may help enhance their overall returns. It may also help them to maintain the right mindset and help them to be psychologically prepared to do business.

Bottom Line
It's often important for a trader to be able to read a chart and have the right technology so that their trades get executed, but there is often a psychological component to trading that shouldn't be overlooked. Setting trading rules, building a trading plan, doing research and getting experience are all simple steps that can help a trader overcome these little mind matters.

[Tom]

Patience and Discipline.

Professional traders know that their emotions are going to affect their trading whether they like it or not. As a result, they develop personalities that allow them to overcome their emotions and trade profitably. Two of the most important personality traits are patience and discipline, because they allow you to handle one of the most difficult aspects of trading.

Making Up Trades

Possibly the most emotional time for a trader is when their profit / loss is negative, and they are waiting for their next trade to come along. During this time they will be impatient and anxious, and they will be desperate to take their next trade in order to make back the money that they have lost. Most new traders (and also many experienced traders) will start taking trades that are not part of their trading system (known as making up a trade). As soon as this happens, their loss will increase, and will continue to do so until they realize what they are doing and correct their behavior.

Accepting Your Emotions

The solution to emotional trading is not to try and remove or control your emotions (good luck if you decide to try), but to develop character traits that allow you to control your response to your emotions. By developing a personality that counteracts your emotions you will be able to continue making logical decisions, even when your heart is pounding and sweat is streaming down your face (maybe this is a slight exaggeration).

Patience and discipline are vital personality traits for professional traders. Being patient allows you to wait for your next trade regardless of your current profit / loss, and being disciplined allows you to take only trades that are part of your trading system (not making up a trade). For some traders, the thought of losing money is enough to make them instantly patient and disciplined, but for others, the emotions are too strong, and they need to cultivate their patience and discipline.

Trading Log

One method of learning how to be patient and discipline is to keep a detailed log of every trade that you take. At the end of the day (or week, or month), replay every trade, and compare the replayed trades to your trading log. If there are any differences, you should be able to determine what caused them, and hopefully know what you need to avoid the next time.

Another method of becoming patient and disciplined is to have absolute confidence in your trading system. Knowing that your trading system will make money over the long term can be enough to overcome the negative emotions that occur when you are experiencing a negative profit / loss. The only way to have confidence in your trading system is to test the system thoroughly. If you have tested your trading system over a significant length of time, and it is consistently profitable, there is no reason to question that it will continue to be profitable.

[Jennifer]

What is trading psychology?
Trading psychology is the perception change that you go through once you are actively in the markets trading your own money. When trading on a demo account, it seems like it would be easy to make money and there seems to be no reason why you wouldn't be able to start making money with a live account. Then, you make that first live trade and you start to feel indecisive about when to take profit, or cut your losses. You have just discovered the effects of trading psychology.
How does trading psychology affect your trading?
Trading psychology can affect your judgment while you are trading. There are two emotions in particular have been the source of ruin for forex traders over the years. Those two emotions are fear and greed. Fear will cause you to either not make a trade when the opportunity arises, or to close a trade prematurely without giving it a chance to be profitable. Greed will cause you to make trades that are too large or too risky, while trying to make massive gains.

How to beat your emotions
The best way to combat trouble with trading psychology is by making a trading plan and sticking to it. Use well thought out risk management and don't get in over your head. Remember that mastering your emotions will allow you to seize the real profit from the markets while emotions are high for others. If you can master your emotions and follow good risk management practices, you can be a successful forex trader.

[Tom]

Focus On Winners - Not Losers

There's an old adage in the market that a trader should always focus on protecting downside and not worry about the winners, as they will take care of themselves. Any trader who's been around for a bit of time will tell you that's faulty logic.

It goes without saying that a failure to protect the downside and cut losses short is a quick way to blow up an account or end a trading career. That aspect of trading must be automatic; much life breathing is to life. Unfortunately, many traders over-focus on their fear of loss and allow trading anxiety to negatively influence their trading.

Finding success in trading is an altogether different proposition - one that requires the knowledge and discipline to focus on and properly manage winning positions to obtain maximum gain prudently.

Justifying Each Trade

The groundwork for success in trading is laid before a position is ever taken - when the trader assesses a possible trade by working through a process of justifying the action. It's at that time that the ideal entry price and the stop and target prices will have been identified, along with important insight as to the overall profile or "lay of the land" for the instrument - all important elements in trade management and maximizing gains.

The justification process involves identifying all of the relevant spots on the chart, along with strategy-specific variables, that one must be aware of before entering a trade, including:
•Key levels (near and longer-term retracement levels, extended targets, daily pivots, gaps, current/recent/historic price points of significance, etc.)
•Near-term and historic trends and trend lines
•Current chart patterns/formations
•Average daily price range
•Key moving averages
•Current price in relation to its opening range
•Volume/comparative volume
•Additional price or indicator variables specific to a strategy

That same process and awareness holds true for the broad market and closely aligned sector indices, as well as correlative issues (be their relationship lockstep or inverse), such as gold, oil, treasuries, dollar, etc.

Other key variables that must be considered include the recent/current volatility in the market, price movement and velocity (Are moves structured and tradable?), time of day, the trade cycle (e.g. key expiry periods, etc.), how "played" or exhausted the tape is in the current session, the normal trade profile for the instrument being considered, etc.

Remain Disciplined

Once in a trade, gain management becomes a process of remaining disciplined and allowing the trade strategy to unfold. The information and insight gained during the aforementioned justification process regarding normal price movement (swing and range) and likely stopping points enables a trader to do just that. Armed with that insight, an individual can enter a trade with a good understanding of the spots on the chart they'll likely be dealing with, enabling them to better manage the position through the normal ebb and flow of price movement with confidence.

Let The Winners Run

Ultimately, the key reason many traders fail is due to the fact they don't recognize the likely levels and normal trade characteristics (of the instrument traded) that will come into play once they've taken on a position. As such, they succumb to the fear of giving up any amount of gain and fall into the trap of cutting winners too quickly. They never allow their strategy or trade plan to work to fruition.

Inversely, good traders enter each trade secure that their downside is covered by a reasoned stop, eliminating fear of loss and enabling their full attention to be placed on managing gains. They have their exit strategy planned before the trade is entered. Their focus once in a trade is singular - choosing where they will exit based on their insight and on what's happening on the ground, refusing to succumb to fear or to be chased out of gains at the first sign of trouble.

[Tom]

The Holy Grail of Trading

It is widely believed by new traders, that there is a single trading system (i.e. a single set of trading rules), that is composed of a small group of technical analysis indicators (e.g. two stochastic lines and the MACD), with a certain configuration of technical indicator settings (e.g. twenty bar and thirty bar stochastic lines and a fifteen bar MACD), that can be traded on any market using any trading style (i.e. scalping, day trading, swing trading, or position trading) and always makes a profit. Many new traders spend years searching for the holy grail of trading, believing that it is the key to their being a consistently profitable trader. If you are one of the new traders that is (still) looking for the holy grail, today is your lucky day, because the holy grail of trading is revealed in the very next paragraph.

The Holy Grail of Trading Revealed

The holy grail of trading is ... that there is no holy grail of trading. I will repeat that just in case there is any doubt ... the holy grail of trading is that there is no holy grail of trading. There is no trading system, no group of technical analysis indicators, and no configuration of technical indicator settings, that is guaranteed to make a profit. Disappointed? Well, don't be, because knowing that there is no holy grail of trading is a big step towards becoming a consistently profitable trader.

The Underlying Principles of Financial Market Price Movement

Instead of spending years searching for the holy grail of trading, new traders should spend their time watching financial markets and learning how the various aspects of financial market price movement interact with each other.

An example for short term traders (e.g. scalpers) might be watching the time and sales (also known as the tape), focusing on the ebb and flow of the buying and selling, looking for repeating patterns in the price movement. An example for long term traders (e.g. swing traders, position traders, etc.) would be reviewing many years of market data (i.e. the previous trading information) looking for price and/or indicator patterns that occur at significant prices (such as yearly highs and lows).

By watching the financial markets, keeping a detailed log of anything and everything, and painstakingly analysing your log, you will develop an understanding of why and how the financial markets move. With this understanding, you will be able to choose (or develop) trading techniques or trading systems that are based upon the underlying principles of financial market price movement (e.g. market dynamics such as supply and demand), and you will then have a significant advantage over the traders that are still searching for the holy grail.

Almost the Holy Grail of Trading

Having said (rather clearly) that there is no such thing as a holy grail of trading, there is something that is close to being a holy grail of trading, but not in the sense that might be expected. The closest thing that there is to the holy grail of trading is to learn a professional trading technique (i.e. a trading technique that is based upon the underlying principles of financial market price movement).

Learing a professional trading technique will not guarantee that you will become a successful trader (hence it is not the holy grail in the expected sense), but learning a professional trading technique is the only thing that will even give you a chance of becoming a successful trader, therefore it is the closest thing to the holy grail of trading.