A library could be filled with books on the psychology of trading. Psychology can be an aspect of trading that is difficult to master because everyone reacts to market movements in their own unique way. Money management is central to any trading plan but psychological management is also very important. There is such a thing as psychological capital as well as financial capital. Both can be depleted.
Supply and demand is a fundamental driving factor in the economy but emotion can often be the primary driving force for a trader. Markets are driven by emotions of fear, hope and greed. The psychology of trading is a powerful force. In boom times markets can be overtaken by, in the words of Alan Greenspan, “irrational exuberance.” On the other hand, markets can plunge in panic and fear as investors stampede for the exit doors. This is one of the reasons novice traders should start off risking small amounts of money so that they can acclimatise to the trading environment Learning to cope with the volatile nature of markets is hugely challenging. It requires patience and discipline. An oft quoted mantra is that we cannot control the markets but we can control ourselves. The longer you trade the more you will understand your psychological strengths and weaknesses.
It is worth pointing out some of the common pitfalls that can affect the pscyhology of trading.
Stick to the plan
If you have done your homework and researched your trading plan you should be confident that it will produce profits. The only way to establish confidence in the plan is to stick to it. Don’t try to reinvent the wheel for each trade. Changing the decision making criteria every time you trade is not a system and will deplete your psychological capital because of its random nature. It makes it impossible to evaluate the trading system and identify possible improvements.
A few winning trades go your way. It might even be the first few you ever execute and overconfidence sets in. Be wary of increasing your position sizes by too much after a winning streak. If anything, decrease the stake. Keep to your money management limits. Just because a particular trading set up has worked the last ten times does not mean it will on the next occasion.
Be patient and wait for the trading system to generate an entry and exit signal. If you miss a trade don’t try to chase the market but wait for the next signal. In particular, if your account is down 30% to 40% the temptation is to trade more and bigger to try and make up for the losses. Don’t! In fact, you should stop trading because it is unlikely you are in the correct frame of mind to trade and you’re probably breaking the trading rules. If the trading plan has been rigorously tested then this scenario shouldn’t arise. Unfortunately, however, traders being human often end up in this position.
Review the first table on the risk management page. A loss of 40% requires a 67% profit just to get back to where you started. If you’ve just lost 40%, what are the chances of making 67%? It’s not going to happen. From the point of view of psychology of trading you are in a very vulnerable position. Take a break for a couple of weeks and go back and review the trading plan. When you resume trading, stick to the original percentage risk per trade. Patiently build up the trading account again. Don’t try to make all the losses back quickly.
Don’t trade without them. Stop losses preserve capital and give peace of
mind. With a stop loss, even if the market turns dramatically against your
position, you capital will not disappear in one trade. It happens!
However, traders have a love/hate relationship with certain types of stops, particularly stop loss orders. This is discussed on Trading Order Types.
Enjoy! You’ve worked hard for them.