A few months into the new millennium, a book that became the trading psychology bible was released. We are talking about ‘Trading in the Zone: Master the Market with Confidence, Discipline, and a Winning Attitude.’
The late author and trading psychology coach, Mark Douglas, wrote this seminal book, exploring themes of risk, randomness and probabilities, which all form part of trader psychology.
Much of the battles traders face are internal. Your brain can be your greatest weapon but also your downfall, depending on the thoughts fed into it.
Profitable trading is as much about controlling your emotions as it is about having the best strategy. This is why understanding the psychology of a trader is essential.
What is trading psychology?
The psychology of trading refers to a trader’s mind or mental state and how it affects their charting decisions. This applies to any financial market, whether FX, crypto, options or stocks. Each trader has their individual and inherent behaviors influencing their actions.
The uninformed person will assume that trading successfully is about making objective technical conclusions not influenced by feelings. Of course, that is the whole point. Yet, trade psychology plays a major role in how good or bad these decisions become.
Although experts advise investors to be as ‘robotic‘ as possible, we are humans at the end of the day. Let’s make a simple example.
However, something kicks into your mind suggesting that this trade will move further in your direction. Furthermore, you seek evidence from many places like the chart, economic news or even confirmation from a friend.
Your trading mentality will naturally turn to greed as you add multiple positions or ‘scaling in’. You know that this is a dangerous action that can quickly lead to a margin call or blow your account. However, because we are programmed to be excessive, ramping up your risk will feel like the right thing.
Unfortunately, the position starts going against you as soon as this happens. Before long, your account is at zero. Even though opportunities to reduce the loss were there, greed would have made the trader overconfident.
This is one of many examples of trading psychology in action. A profitable trader with a sharper trading mentality will have done things differently. They would have recognized the risks of adding multiple positions and devised a plan beforehand to manage them.
It’s not to say greed is always a bad thing. Scaling in forex is an advanced money management technique that works wonders but should be practised carefully.
So, this is the point of trading psychology. Natural human instincts are difficult to ignore. Yet, the key is ensuring you can consistently make sound trading decisions.
Common trading psychology biases (and why they should be avoided)
The psychology of trading revolves around preferences triggered by specific individual emotions. Identify these whenever they show up and avoid them at all costs.
“Past performance doesn’t guarantee future results.”
“Hindsight is 20/20.”
All traders have heard of these phrases. Trading is a challenging endeavour because you’ll only know the new direction of a market once it has materialised. There is no crystal ball; we are taking a risk on the unknown.
Hindsight bias means traders discern past events as more predictable than they actually were. This can offer them a trading mentality of overconfidence when looking at new opportunities.
Also, if they were to miss a trade, they would feel regret, excessively contemplating what could have been.
This trade psychology refers to how people look for information that confirms pre-existing beliefs while disregarding contrary signals. Confirmation bias has similarities to hindsight bias. For instance, it’s simply to have strong feelings that a certain market will increase.
This may be based on seeing a past chart pattern, looking at new evidence or pure favouritism. Yet, having confirmation bias is unproductive because the trader wouldn’t consider a holistic picture and factor in what can go wrong.
It’s easy to frame the psychology of a trader into focusing on the present. Recency bias suggests that people give greater importance to recent events than older ones. It’s prevalent when traders face a losing streak (but it also applies to winning streaks).
When you’ve lost two trades in a row, it’s easy to assume that the next one will have the same outcome. This can lead to analysis paralysis or fear of taking that next trade because of potentially experiencing a loss.
Hot hand fallacy
The hot hand fallacy is the concept that a trader will continue to experience a run of good luck after the first or first few successful attempts.
It has some resemblance to recency bias because traders often gain more confidence if their recent positions went favorably. The hot hand fallacy can be a destructive trading mentality because it produces unnecessary overconfidence.
Also, it doesn’t factor in that the outcome of each position is independent of the previous.
Improving your trading psychology
Here are quick-fire tips so that you can have an elite trading mentality.
Control the ‘Four Horsemen’ of trading emotions
Of all the emotions traders can experience, these tend to be the most common: fear, greed, hope, and regret.
- Fear: a bit of fear can be technically a good thing. Yet, it can lead to recency bias during hard times, resulting in missed opportunities.
- Greed: almost always a bad feeling because it usually results in overleveraging.
- Hope: unironically a positive emotion in life but not in the markets. It leads to traders having a ‘fingers crossed’ approach. Hope is related to greed as it involves the strong desire for something to happen, which has little to no risk management.
- Reget: prevents you from moving on to new opportunities because you get stuck in the past.
Appreciate the probabilistic nature of trading
Mark Douglas put it best in ‘Trading in the Zone’ when he wrote of the five truths in the financial markets:
- Anything is possible.
- There is no need to know what will happen next to make money.
- Wins and losses are randomly distributed.
- An edge only indicates a higher probability; it is never a guarantee.
- The market is unique at every moment.
Read trading psychology books
Of course, ‘Trading in the Zone’ is perhaps the most well-received and popular trading psychology book. But other great titles you should check out include:
- The Investor’s Quotient by Jake Bernstein
- Market Wizards by Jack Schwager
- The Art of Thinking Clearly by Rolf Dobelli
- Sway: The Irresistible Pull of Irrational Behaviour by Ori and Rom Brafman
Consider automated trading systems
A robot can make unbiased decisions with no deviation or uncertainty.
Like anything in life, it’s about balance. Appreciating trading psychology is, of course, essential. Yet, you shouldn’t neglect other attributes of knowledge, skill and experience.
While your trading mentality may be sound, it’s pointless without an edge-defining strategy. It is only a piece of the puzzle, but a significant one nonetheless.