Often overlooked, trading psychology is an important facet of a trader’s skillset, and it can determine one’s overall success or failure in the markets.
No matter your prowess in technical or fundamental analysis, your trading psychology will impact your trading decisions in the market.
Psychology is the study of mind and behaviour, or simply, personality. As such, trading psychology refers to a trader’s mindset during any trading activity.
Humans are emotional beings who are prone to biases, and this can be manifested in their trading activity. It is often said that a trader’s worst enemy is himself, his own emotions and his bias when trading.
The purpose of understanding trading psychology is not to eliminate emotions or biases (they come naturally) but to ensure that they do not hinder objective decision making when trading or developing trading strategies.
Different traders have different personalities, which means that they are influenced by trading psychology differently. Understanding trading psychology, therefore, means that one understands one’s own personality, and particularly the negative psychological traits that can limit one’s success in the markets. It also means building the positive psychological traits that will enhance better decision making in the forex and CFD markets.
Financial markets are by nature fast-paced and dynamic, offering infinite possibilities but also an imminent danger of loss. Real money can trickle in as profits as much as it can evaporate as losses. Any decision made at any given time can have a huge impact on your capital balance.
The goal of trading psychology is to condition your trader mindset. By learning about trading psychology, traders hope to gain a mental edge when trading the markets. It is a way of building awareness of oneself and committing to a positive thought process and trading behaviour that will give you a realistic chance of long-term trading success.
It is a way of building and applying discipline in real-time when trading. When trading psychology is mastered, a trading plan is followed to the letter, level-headed decisions are made at all times, and emotions do not get in the way of objective trading activity.
Emotions in trading can often lead to misjudgements and loss. Here are some of the most common emotions that impact trading activity:
Understanding the fear element when trading is possibly the very first emotion that you go through when you see trading graphs, tickers and information coming at you that you can’t comprehend, and it is a scary concept. You may want to run for the hills, to not even invest just to be safe, however you will stand to lose out on potential gains. Fear can be a limiting factor for not opening potentially profitable positions without properly calculating the risks. Understanding what fear is, would be the first step to overcome the emotion and the drawback you may experience when entering something you know little about. Trading is not a threat, there is little to be fearful of when trading, it simply takes time and knowledge to understand what you are doing, why you are doing it and how it can eventually benefit you.
Fear is best expressed in the market by a phenomenon known as FOMO, a term that originated from stock market psychology to describe the ‘Fear of Missing Out’ on a big opportunity in the markets. It is emotions, primarily fear and greed, that trigger FOMO in the markets. It is the feeling that other traders are making lots of money and it creates an urgent desire to make big profits as well. This desire can lead to committing trading mistakes, such as risking too much capital or even entering unnecessary trades.
FOMO traders fear that they are missing a great opportunity by not placing a certain trade, while simultaneously succumbing to the greed of making profits urgently. FOMO can be triggered by various factors, such as volatile markets, prolonged winning/losing streaks, news and rumours, as well as social media.
FOMO can manifest individually or even collectively in the markets. A recent case is in January 2021 when a discussion in a popular social media forum, Reddit, triggered massive demand for GameStop stock. The stock posted abnormal gains within a couple of days before tumbling again to below its initial price levels.
During the frenzy period, retail investors flocked to join the ‘party’ but many would have counted losses afterwards simply because the trade was made euphorically. To avoid succumbing to FOMO tendencies, a trader should develop and rigorously stick to a solid trading plan that has defined entry and exit rules as well as a reasonable risk management plan.
In the uncertain financial markets where there is an ever-present danger of losing real money, it is very easy for any trader to become frustrated. Frustration emanates from the anger that one cannot have one’s way in the markets. The goal of every trader is to make money consistently out of the markets, but not many get to achieve this. Frustration can come about when a trader experiences perennial loss or a period of huge drawdowns. Frustration is like a bug as it will only grow in menace. It increases self-doubt, which can consequently lead to abandoning a trading plan or even a previous working strategy.
Like a bug, it is best to prevent trading frustration than to fight it afterwards. This means that a trader must become aware of (and even embrace) market risks and always commit to sticking to a trading plan. Traders should also set realistic expectations, and view trading as a long-term marathon rather than a get-rich-quick sprint. But when frustration cannot be avoided, traders should use that period to reflect on their trading activity and avoid past mistakes as well as an opportunity to build on their trading skills and techniques.
Overconfidence is a state of being more confident in your trading decisions and expectations than is logically reasonable. Overconfidence can make traders overrate their abilities and even much worse, underrate prevailing market risks, such as volatility. Overconfidence in the markets can be triggered after a series of positive trades or prolonged luck.
This can lead to affected traders having a misplaced illusion of control that can lead to risky behaviour in the markets, such as overtrading, aggressive market timing, trading big lots, using inflexible strategies, and overlooking volatility risk. Overcoming overconfidence requires one to be honest with oneself about one’s trading abilities as well as to perform careful analysis and follow a strict risk management plan.
Anxiety is also a dangerous emotion in forex trading. It is the feeling of restlessness, tension or persistent worry. When a trader becomes overly anxious, it is a clear sign that something wrong was done or he deviated from his trading plan.
Efficient trading activity requires constant vigilance and heightened awareness. In a state of anxiety, a trader lacks this and is, therefore, prone to poor trading decisions that can result in devastating losses.