What Does Psychology Have To Do With Trading?
From my experience on the World’s trading floors I believe psychology to be the single most important concept to get your head around – so to speak!! So what does psychology have to do with trading? Let’s see how psychology can help you to become a successful trader.
Psychology is a fundamental concept that you need to master if you want to become a successful trader. I can’t emphasize this enough. Having a great trading system and a large funded portfolio is pretty useless if you don’t control the psychological aspect of your trading. More than likely you will clean out your account, as euphoria, anger, panic, despair or denial set in. Trading can be tiring and exhausting – it’s a rollercoaster of emotions.
Understanding who you are is a key priority when trading. Once you start to realize ‘who you are’, you will become a much more effective trader. It is essential that you learn to manage ‘Greed and Fear’ and your emotions – you don’t want your trading to be dominated by them!
GREED and FEAR!!
These 2 words balance the scales on the supply and demand of buying and selling:
Greed: Unfounded hope, euphoria, excitement, ignorance
Fear: Of losing out, of making losses, of making wrong decisions, failure, fear of impending trouble
For example, you are in a trade making money and you want more profit. You hold on, the market turns and now you are facing a loss! Or perhaps you let a good trade go because you are too afraid of losing money. You need to be disciplined – following your trading strategies / plan and adhering to strict money management rules.
One of my most important rules is “Only put a sum of money into trading that you are comfortably prepared to lose.” If you don’t follow this rule, it’s very easy for your emotions to get the better of you and then the psychology of trading plays a much bigger role in your own trading than it should – ultimately this will harm your results.
Let’s look at some of the important issues and concepts around the psychology of trading that will hopefully get you thinking…..
Can Anybody Become a Trader?
Nowadays, with the ability to trade from home, it’s possible for almost anyone to become a trader. However, becoming a successful trader is a little more challenging! In my experience, there is no ideal ‘robot’ trader – successful traders come from all walks of life, academic and social backgrounds, privileged and not. What they all have in common though, which you will come to realise, is a core set of skills and personality traits. So don’t be intimidated – BE YOURSELF!
Above all, you need to learn, practise and persevere. Do you think you could take a few golf lessons and turn up to the British Open and beat Tiger Woods? Everyone knows how to punch but would you step into the ring right now and take on an in the prime Mike Tyson? You can easily read a book on brain surgery…it doesn’t mean you’d be able to operate.
So why do so many people think they can start trading and instantly make millions?! Your ego has the capacity to destroy your trading – in my experience, the bigger the ego, the worse the trader!
Trading is a profession and those who succeed work very, very hard at it over long periods of time. There is no get rich quick scheme that is legal. So forget delusions of grandeur, roll up your sleeves and get stuck in. It’s not an easy ride like some would have you believe. And, of course, there are some people who are simply not cut out to be traders. If you are a compulsive gambler, or at the other end of the spectrum and completely risk averse, then trading really isn’t and shouldn’t be your thing!
What Are The Key Skills of a Good Trader?
All successful traders share a common set of core competencies:
• Ability to listen
• Ability to analyse
• Ability to realise when things don’t add up (common sense)
• Ability to be flexible / adaptable / stubborn at times
• Basic sound numerical skills
• Good decision makers under pressure
Skills that provide traders with essential mental toughness:
• Self Confidence
You need all of the above skills when trading, but still that doesn’t guarantee success. It’s far more complex than that! You must also:
• Be CAUTIOUS
• Be PATIENT
• Show the courage of your CONVICTIONS
• Be DETACHED emotionally from the market
• Have a PLAN
• Be CONSISTENT
• Expect SURPRISES
What Common Problems Do Traders Face?
So you’ve started trading. Think about some of the psychological aspects involved in the examples below – how would you cope with them? These are typical problems faced by professional and amateur traders alike….…..
1. Getting in the trading zone
Like professional sportsmen you have to be focused to succeed. It’s all too easy to get distracted.
2. Fear of putting on the trade
You have to be in it to win it! Some people talk the talk but simply just can’t handle doing it for real!
3. Fear of performance and results
As above, people suffer from trading paralysis!
4. Fear of continued losses
I know that, for example, I can lose 7 out of 10 trades and still be a winner because I have a plan, know my results, trading style etc. I can handle losses!
5. Loss of confidence
You’ve just lost £1m on one trade, you’ve wiped out your annual profits – how are you going to come back from that?
6. Doing too much for the sake of it (over trading)
You’re playing catch up, you’ve lost a lot, you feel you’ve just got to trade your way out of this mess! Or, you haven’t got a plan so you go into it blindly and trade for trading’s sake! Both are recipes for disaster.
7. Knowing when to cut losing trades or take profits
If you get this wrong you can ruin a good trading strategy straight away!
8. Not being prepared
“If you fail to plan, you plan to fail!” – know your market, know yourself – all very obvious!
Don’t let these psychological issues turn you into a Hesitant Trader, Blinkered Trader, Withdrawn Trader or Reckless Trader – fall into one of these personality traps and you are destined to fail!
Be a Smart Trader: The Pareto Principle – The 80/20 Rule
I use this rule all the time in my trading. I was introduced to it by some very smart thinkers at one of the trading firms I used to work for. But what does it mean? Basically, it’s an observation of how, when a large number of factors contribute to a result, that the majority (roughly 80%) of the result comes from a minority (roughly 20%) of the factors. This concept was first suggested by Vilfredo Pareto, an Italian Economist, who noticed that 80% of the peas in his garden were contained in 20% of the pods! In business this might mean that 80% of your sales come from 20% of your clients. The richest 20% in the world make up 80%+ of the income! When trading, do 80% of your profits come from 20% of your trading strategies? Focus on the most effective areas – eliminate, ignore, automate – do whatever to the rest! Have a think -how can you apply this concept to your trading?
Richard Koch has written some great books on this principle including: ‘The 80/20 Principle’(1997) and ‘Living the 80/20 Way’ (2013).
Be a Realistic Trader
Those of you who trade from home need to find the time to sit down and trade properly and according to your trading plan. Do not under estimate the mundane stuff in your life and how it can impact your trading results very heavily on a day to day basis if you are not careful. Especially if you are fully committed to making this your full time occupation! School runs, doctor’s appointments, house maintenance, Christmas shopping, kids hobbies, tax returns, bills to pay etc. etc. – these are just some of the things that can get in the way of your trading plans.
So number one tip – BE REALISTIC!
Also, have some FLEXIBILITY in your trading plan and your expectations and be ADAPTABLE, not just to the ever changing situations in the market place, but also your own personal situation!
You Won’t Win Every Trade!
Your personality will be the key to your trading survival, but whatever your personality or background, it is essential that you learn to deal with losses. Some tips:
• Avoid chasing after the perfect system that promises to eliminate losses.
• Don’t equate losses with failure. In fact, complete elimination of losses should be seen as a failure — you are likely to have eliminated most of your gains as a consequence.
• Distinguish between abnormal losses and the small losses normally incurred by any trading system.
• Accept that small losses are an unavoidable part of trading — and that you will regularly incur them. They are as much a part of trading as are profits.
• Most successful traders enjoy success rates no greater than 50%. What they are able to do, however, is to restrict the size of their losses while realizing substantial gains on their successful trades.
• Focus on the collective effect (maximizing your overall gain) rather than on the impact of individual transactions.
• Practice sound money management to restrict the size and frequency of your losses.
Use Your Head for Better Trading Results
In the corporate world, Investment Banks and Trading Houses often employ psychologists to help out their traders, but it is still an under-utilized resource in world of trading generally. So, I guess the main message I am trying to get across here, is that you need to start your trading by getting the right training and coaching and being in the correct environment to learn. On top of this, you need to have a plan, be prepared, be consistent, put in the hard work, analyse and learn from your mistakes, and constantly evolve as you gain experience. By putting all these things together, you will more than likely see a significant improvement in your results.
Some 2,500 years ago, Sun-Tzu posited in his book on military warfare (The Art of War) that “Every battle is won or lost before it is fought”. This is certainly the case when trading, so use your head!
For more on this topic read: “The logical Trader” by Mark B Fisher.