The Importance of Trading Psychology and Discipline
Trading in the financial markets is a highly technical activity. To become successful as a trader, you need good understanding of the financial markets and how they work, you need a good understanding of the companies you trade in, you need the technical expertise to analyze market trends, as well as a great understanding of the factors that move the market.
Still, even with all these technical skills, it is impossible to become a successful trader if you lack one key attribute – the trading psychology.
The trading psychology is basically the right mindset and the ability to think on your feet, remain disciplined and exercise control over your emotions even when the market is going against your expectations.
Wondering why I term trading psychology as the most important attribute of a successful trader?
Consider the scenario below.
A trader is watching the markets waiting for the right moment to get involved. Naturally, our trader is afraid of losing money, so it is understandable that he is acting a bit cautiously.
He waits for a better support line before getting into a trade, but then he misses the entry and the markets take off without him. Nothing to worry about though.
He decides to wait a bit and catch the next wave, but because he is afraid of taking risks, he misses the next entry as well. This happens a number of times.
While this is happening, our trader is talking to other trader friends and interacting with other traders in various online forums and groups.
All the other traders are talking about the great profits they have made in the last couple of weeks, yet our trader has not entered a single trade.
The fear of taking risks starts turning into greed. He starts feeling like he is missing out on all the profits others are making, and he starts feeling anxious and kind of frustrated, even if he has not lost any money.
To avoid continuing missing out while others are making money, our trader decides to take a risk next time.
Driven by greed, he throws all caution to the wind and jumps onto what seems to be a promising trend without conducting due diligence.
Unfortunately, the markets turn around.
Before, he wasn’t losing any money, but now he is, and instead of taking a loss, he decides to hold onto the trade in the hope that the markets will turn around and allow him to recoup the money he has just lost.
Unfortunately, the trend continues, and he loses more money. The frustration of losing turns into anger, and he starts thinking of how to recoup all his money.
Assuming that the markets cannot go any lower, he decides to put more money into the trade at this point so that he can cancel out his losses and make a tidy profit, because surely, there is no way the prices will keep falling.
But as any successful trader knows, the markets are not rational, so the downward trend continues, and our trader ends up losing all his money.
Depending on how much money he lost, our trader might even get into depression.
The above is a great illustration of how allowing emotions to run amok can make you lose your better judgment and impact your success as a trader.
Every successful trader knows that the markets are constantly testing traders, and anyone without the right psychological mindset and the ability to control his emotions will have a hard time making the right decisions.
Aside from having the right mindset, traders also need the discipline to stick to their trading plans and strategies regardless of what the market throws at them.
The above illustration is just one example of how your psychology can affect your trades.
Below are several other trading issues that are usually caused by a trader’s psychology.
- Not taking loss: The typical reason behind this is usually that the trader is afraid of failure, which puts his ego at stake.
- Exiting trades too early: This is usually caused by the trader’s need for instant gratification. The trader is anxious and fearful that the position might reverse, so he decides to close the position to relieve the anxiety.
- Averaging down: This refers to situations where the trader is unwilling to admit that their trade is wrong. Hoping that the trade will come back, the trader adds onto the losing position. This is also caused by the trader’s ego.
- Wishing and hoping: This manifests itself when traders execute trades based on their hopes and wishes, rather than following the market situation.
- Compulsive trading: This happens when a trader gets addicted to trading, in similar fashion to how gamblers get addicted to gambling.
- Feeling invincible: After a series of winning trades, some traders might feel like they are invincible and in control of the markets. This often leads to risky trades.
- Second guessing your signals: This is often caused by the fear of failure and the fear of being wrong. Traders who second guess their signals usually have a hard time accepting that loss is a natural part of trading.
- Trading a large position size: This is often caused by the disillusionment that a trade can only turn out to be profitable, as well as poor risk management.
- Excessive trading: This is caused by greed, and a need to conquer the market. It can also be caused by anger, when a trader is trying to make up for previous losses.
- Being afraid to enter positions: This is usually caused by fear of failure, risk averseness, need for control fear of being ridiculed, or lack of a trading system.
There are many more trading issues that are caused by the trader’s psychology, but these are by far the most common.
When going through the above situations, you might have noticed that majority of psychology related issues are usually caused by three emotions – fear, greed and anger.
These three emotions play a very significant role in a trader’s psychology, and any successful trader must learn how to put them in check.
Let’s take a look at how these emotions might affect your trade.
Fear is a natural human reaction to anything perceived as a threat – in the case of trading, the threat is the possibility of losing money.
The larger the potential loss, the bigger the amount of fear experienced. Fear during trading manifests itself in a number of ways.
The most common manifestation of fear is being too afraid to get involved.
Like our trader from the example up above, your fear of losing money makes you too cautious, and as a result, you end up missing all your entries.
While being cautious is an important trait, being overly cautious to the extent of missing all your entries turns into a disadvantage, because you are not going to make any money in the market unless you actually get into trades.
Sometimes, the fear might come when you have already entered a position.
Some breaking news about the stock you are trading or the general market might cause a temporary movement in the market.
In such situations, a fearful trader might be compelled to exit the position before their preplanned exit to avoid losing money.
While such a fear-driven exit will help you avoid certain loss, it also prevents you from making gains once the market recovers from the temporary volatility caused by the news.
Alternatively, someone might exit a position early because they are afraid of holding a position for more than a day.
The first key to overcoming fear as a trader is to understand that losing is a natural part of trading.
It is impossible to trade without losing. Even the most successful traders experience losses from time to time.
You can think of loss as the cost of doing the trading business.
Once you understand that losing is a natural part of trading, your perspective changes from being afraid of loss to trying to manage your losses.
One of the best ways to overcome fear by managing loss is to have a trading strategy. If you trade without a strategy, you are more likely to be swayed by your emotions.
Having a strategy, on the other hand, keeps you grounded even when the markets seem to be going against you.
For instance, if your strategy wins 70% of the time, you will be expecting a few losses here and there.
Therefore, having one or two losing trades will not cripple you with fear, because you will be comfortable with such losses.
Another way to overcome your fear is to start slowly and gradually build your trading experience. Instead of leaping into the waters hoping to make big bucks, start with stocks that have slow and small movements, and only trade small position sizes.
As you get continue trading, you will gain a better understanding of the markets and what to expect, which will make you less fearful once you decide to start taking bigger and bigger risks.
Greed is the opposite of fear.
Whereas fear keeps you from trading or causes you to exit out of positions early because so as to avoid loss, greed pushes you into risky trades and causes you to hold positions for longer than you planned to with the hope of making huge gains.
Greed is often caused by the fear of missing out (FOMO). This usually happens in one of two ways. The first one is where you see other people making huge gains in the market while you haven’t made any significant gains.
In order not to miss out on the gains others are making, you abandon your trading strategy and enter trades at the wrong time.
Alternatively, FOMO might also come into play when the market exceeds your expectations.
A trend continues beyond your planned take profit levels, and instead of taking profit, you discard your strategy and continue holding the position because you are afraid of leaving more profits on the table.
Unfortunately, if the markets reverse, all the gains you had made can easily get wiped out in a matter of seconds.
As a trader, overcoming greed can be quite challenging, because it is often caused by the drive to do a little better or make slightly bigger gains.
However, there are two main approaches to overcoming greed.
The first one is to stop concerning yourself with what your friends and other traders are doing or the huge gains they are making.
As a trader, all your focus should be on your own trades and your own results.
You should be driven by the desire to improve your trading strategy, rather than the desire to make what others are making.
The second one is to have the discipline to stick to your plan.
When coming up with a trade plan, there are no emotions involved. Instead, most traders come up with a trade plan based on a careful and rational analysis of the market.
While it is definitely tempting to put aside the plan when things seem to be going well for you, if you want to become a successful trader, your best bet is to stick to the plan, learn what you can from the experience of leaving money on the table, and then put that new knowledge into consideration when coming up with a plan for your next trade.
This way, you will gradually improve your trading strategy while at the same time learning to overcome your greed.
This emotion rears up its ugly head when you have been unable to control the other two emotions, resulting in your trades going against your expectations. You start feeling frustrated.
Anger is almost always targeted at something or someone – in this case, anger is usually targeted at the market. In a bid to get back at the market, angry traders will often find themselves engaging in revenge trading.
For instance, let us assume that a trader is in a winning trade that has already reached the trader’s planned take profit point.
However, due to inability to control his greed, instead of taking profit, the trader decides to continue holding the trade in the hopes of hitting a home run.
Unfortunately, the market reverses and all his gains are wiped out.
At this point, he is back to where he started. While the gains he had initially made have been wiped out, he still hasn’t made any loss.
The thought of all the gains he had and failed to take, however, makes him angry and frustrated.
Instead of closing the trade at this point, he might decide to wait for the market to reverse again so that he can at least close with a slight profit.
Unfortunately, this doesn’t happen, and his trade now goes into loss.
Some traders might get off at this point, while others might even average down in the hope of recouping their losses, which will most likely lead to even greater losses.
The key to preventing anger is to stick to your plan. Not only does this give you control over the other two emotions that lead to anger when they spin out of control, it also prevents you from making a mistake such as averaging down.
HOW TO IMPROVE YOUR TRADING PSYCHOLOGY AND DISCIPLINE
Most novice traders like to think that they are rational beings who will trade solely based on data and facts. As we have already seen, however, this is rarely the case.
Unless you are not human, emotions will always come in and try to cloud your better judgment.
The key to becoming a successful trader is to improve your trading psychology and discipline so that you can minimize the effect of emotions on your trading.
Below, we take a look at tips that will help you improve your trading psychology and discipline.
Always Have a Plan
If you want to generate money through trading, you should treat it like a business.
Would you invest your capital in a bakery, restaurant, or any other traditional business without a business plan? Probably not. Why then do people get into trading without a plan?
If you want to make money with trading and avoid the psychological crunch that comes once the market decides to test you, you should go into every trade with a plan on how you intend to make money.
Before getting into the trade, determine your entry point, determine your risk-reward tolerance, and determine how you will exit the trade – either through a predetermined profit target or a stop loss.
Having a plan not only increases your chances of making money, it also gives you something to fall back on when things start going awry and your emotions start trying to influence your trade.
However, having a plan is not all. You also need to have the discipline to stick to your plan.
A plan is absolutely useless if you are not going to follow it.
Many are the traders who start with a plan only to abandon it when their emotions get into the picture.
Therefore, you should make a commitment to yourself that you will stick to your plan no matter what happens in the market.
This is one of the best ways of strengthening your trading mentality.
Be Prepared to Lose
Regardless of how good you are and how much analysis you have done, you can never be 100% certain how the trade will go.
Therefore, as much as you want your every trade to be a winning trade, you should be prepared to lose.
Before getting into the trade, take a moment to think about everything that could go wrong. Doing this has two advantages.
First, thinking of all possible ways the trade could go wrong allows you to come up with a detailed plan on what to do in case this happens.
Therefore, instead of having knee-jerk reactions when things don’t go as expected, you will already have thought about what to do in such cases.
For instance, if the market is on an upward trend, before getting in, you should think about what point you will cut your losses in case the market reverses just after you enter a position.
Second, thinking about losing gives you the opportunity to consider how it might feel in case your trade turns out to be a loser.
This way, if the trade goes awry, your emotions won’t catch you unawares.
Instead, you will already know what emotions to expect and will be better prepared to keep these emotions in check.
Research Continuously to Increase Your Knowledge Base
Constantly increasing your knowledge is one of the best ways of improving your trading psychology.
The more you know about the markets and their behavior, the better you will become at making decisions and navigating any curve balls that the markets might throw your way.
When faced with a situation you have never experienced before, you are more likely to react to it calmly if you had read about it the week before.
On the other hand, a trader realizing for the first time that such situations exist when there money is at stake is more likely to react with panic.
The popular saying that practice makes perfect is popular because it is true.
No matter how much research you do, you are unlikely to learn everything about the market by research alone.
The only way to learn about the market and what to expect from it is to trade and learn by yourself.
In addition, practicing allows you to try what you have learnt. Think of it like riding a bicycle.
No matter how much you read about riding a bicycle, the only way to learn to actually ride is to get on a bicycle and give it a try.
Similarly, regardless of how much research you do, the only way to actually improve your trading psychology is to put what you learn into practice.
Fortunately, many trading platforms and brokers provide demo accounts that allow you to practice without risking real money.
While having the technical knowhow of trading is important, your trading psychology and discipline is equally important.
Regardless of how much you plan and perform market analysis, not having control over emotions such as fear, greed and anger can easily lead you to abandon your trading plan and make poor decisions.
This is why developing the right trading psychology and discipline is very critical to your success as a trader.
Fortunately, you now know how the mental aspect of trading affects your career as a trader, and what to do in order to develop the right trading psychology.