What Is Trading Psychology?
Trading psychology refers to the various aspects of an individual’s character, mental state, and behaviours that affect the actions they take when trading.
Understanding Trading Psychology
Trading psychology looks at the emotional aspect of a trader’s decision-making process to determine the success or failure of a trade. It focuses on two distinct subjects – the trader and the market – to analyze the behaviour of financial markets relative to the instincts, emotions, knowledge, experience, skills, and thoughts of the traders who participate in it.
Understandably, trading psychology differs from trader to trader as it is influenced by the trader’s emotions, biases, and other varying factors. Fear and greed are two emotions that are often regarded as most likely to affect the success or failure of a trade, while hope and regret also play decisive roles.
Greed is the excessive desire for profits to the point that it clouds the rationality and judgment of a trader, thus driving decisions that appear to be too risky.
A greed-driven trade may range from buying stocks of companies that don’t have a sound reputation just because they are on the rise or buying shares of a company without understanding the investment.
As a result, greed can make a trader stay in a position for far too long than they should and against their better judgment in an attempt to get every cent out of the trade. This often happens at the end of a bull market when traders attempt to take on risky and speculative positions to profit from the market movements.
On the other hand, fear drives traders to avoid risks thus generating lesser returns from their investments. Fear makes traders act irrationally when it comes to exiting a trade, thus going short prematurely or avoiding taking on risky positions out of concerns of suffering losses. This kind of emotional trading based on fear is common during bear markets, where we can see significant selloffs from panic selling.
Learning about trading psychology can help traders be more aware of their emotions so that they will know how to handle the market and their trading positions during undesirable market conditions.
Behavioural Finance Explained
Behavioural finance looks at the cognitive, emotional, cultural and social behaviour of investors and their impact on financial markets.
For finance professionals and serious traders, learning about behavioural finance is an important part of their journey as understanding the psychology, economics, and other social sciences that drive people to make certain financial choices can help craft a more effective trading plan and build better portfolios.
According to Investopedia, there are five basic concepts that typically make up behavioural finance:
- Mental Accounting – This refers to the tendency for people to set aside money for specific purposes.
- Herd Behaviour – This refers to the tendency of people to follow the financial behaviours of the majority of the herd. Herding is known in the stock market as the cause behind dramatic price movements.
- Emotional Gap – This refers to decision-making based on extreme emotions or emotional strains. These emotions are often the reason why people do not make rational choices.
- Anchoring – This refers to the tendency of people to attach a spending level to a certain reference.
- Self-Attribution – This refers to the tendency to make choices based on overconfidence in one’s own knowledge or skill.
How To Avoid Emotional Trading
One of the major objectives of learning about trading psychology and behavioural finance is to gain a better understanding of how the market operates and of one’s financial decisions in reaction to the movement of the market in order to avoid emotional trading.
Emotional trading, as the words suggest, refers to the act of trading driven by high emotions instead of rational thinking and sound reasoning. It happens when a trader or investor allows their personal feelings and emotions to impact their decision-making.
By having a good grasp of trading psychology and behavioural finance, a trader or investor can effectively navigate volatile financial markets while keeping their behavioural impulses of emotional buying and selling that can come from following the market’s ups and downs in check.
Emotions cannot be avoided, but taking a step back and examining them can be an invaluable tool, along with good investment practices such as setting goals and targets, risk management through diversification, hedging, and proper money management.