Trading Psychology - It’s all in the mind

Trading psychology refers to the emotions and behaviors that traders face under different situation and their reaction to different situations whether good, bad or unexpected. Trading psychology is a vast field in itself.

But what drives these reactions in the moment when the situations arise? There are two types of biases that drive the reaction of traders: Cognitive bias and Emotional bias. Bias is defined as inclination or prejudice towards something or someone. In trading psychology, bias usually means inclination towards emotions or irrational thinking.

The Two Biases

Cognitive bias is systematically deviating from rational thinking. These biases affect the ability to process and interpret data. This in turn affects the ability to make rational decisions and judgement. For example, when a trade fails or is about to fail, the trader may deny the fact that the trade is failing and chooses to look for proofs that would validate his reason for taking the trade. This results in untimely exit from the trade. The losses faced could have been mitigated if the trader would have accepted the failure and exited the trade on time.

Emotional biases are in play when the reaction from the trader is influenced by emotions rather than rational thinking. These emotions could be greed, over confidence, regret, fear etc… These biases result in the trader taking the wrong trades, too many trades or limiting the trader take any trades.

It is also possible that these two kinds of biases can influence a trader at the same time.

How to deal with these biases?

There are 5 ways to avoid Cognitive and Emotional biases:

• Have a trading plan

• Have a disciplined and consistent approach

• Risk management

• Managing losses and Drawdowns

• Achieve long term sustainability

Have a trade plan

Having a trade plan mitigates most of the cognitive and emotional bias. The trade plan includes objective entry, exit, stock selection and holding period. Make sure everything is objective and rule based. The actions of the trader must be based on the rules set in the trade plan.

Having a trade plan will stop the trader from looking at the price from minute to minute. If the holding period according to the strategy is for months, why should the price action of 15-min affect the position? Not looking at the price frequently will stop the emotions from having influence.

Have a disciplined and consistent approach

Being disciplined is important. Once the trade plan is made, be devoted to the plan and avoid deviating from the trade plan. If, according to the trade plan, the target is 10%, then exit the trade after the target is achieved. Even if the price moves beyond the target, there is no need to regret the lost returns. It is wise to look for new trades rather than wasting time on regrets.

The trick is to be aware of the emotions and take control of them.

Risk management

Have a defined amount risk. The risk could be per trade, per day, or per strategy. Risk management is a technique to avoid wiping out the capital and keeping the profits already made. For example, if the style of trading is intraday basis, then the risk can be limited to an absolute amount per day.

Managing losses and Drawdowns

Everyone faces losses. It’s okay. It’s part of the game. It is also possible that the trader or the strategy might be facing losses consistently. This can be emotionally taxing. It is better to take a break and reevaluate the strategy. It is also wise to have a few strategies in okay at the same time.

Achieve long term sustainability

Instead of having a short-term view, it is better to set a long-term view. There are always opportunities to trade. The self inflicted short term pressure of earning certain return can indirectly affect the trade decisions. Unpredictability is the inherent nature of the markets; the trades may not go as planned. It is important to have patience and set a goal that is reasonable.

I explain trading psychology in-depth in this YouTube video. Spend a few minutes and do watch it.