When we talk about trading in the stock markets, we tend to focus a lot on charts, analysis, market sentiment, company’s performance, and other external factors. Even when we talk about the skills needed by a trader to be successful, we focus on knowledge and awareness of the markets, analytical ability to read and identify patterns from charts, etc.
One of the oft-ignored but critical aspects is the psychology of trading. Most of us would have heard experts talk about not making emotion-driven trading decisions. While that sounds logical, human emotions are complex. This article is dedicated to trading psychology. We will talk about specific emotions to avoid and latch on for a successful run as a stock trader.
Let’s begin with a psychology lesson:
Psychology is a study of mind and behavior. Hence, when we talk about trading psychology, we focus on most of the feelings and emotions a stock trader encounters while trading. Like in most aspects of our lives, understanding how our mind responds to certain stimuli and what it makes us feel can lay the foundation for a controlled mental state – a skill essential to be a successful trader.
Human beings have complex emotions. For example, even if a stock price is falling, you might decide to hold on to it because you have been a regular consumer of a product offered by the company and believe in it. The emotion in play here is ‘admiration’ that does not allow you to look at the data but take additional risks. While we are not saying that emotions are bad, it is important to know when to curb them to avoid major losses.
Traders that have better control over their feelings and emotions tend to make more logical decisions as compared to those to follow their ‘feelings’.
While we experience a range of emotions on any given day, there are some prominent ones that we would like to talk about today.
One of the first emotions that come to mind when talking about stock trading is FEAR. It is a natural emotional reaction to a perceived threat. When you place a trade, you expect the market to move in the anticipated direction. Fear starts creeping in when the movement is in the opposite direction. The potential loss instills fear in the mind of the traders and causes them to make sudden decisions of squaring off their positions without a plan. Since human beings are designed to combat fear is ‘fight or flight’, most traders opt for the flight (or redeem) option since they cannot fight the direction of movement of the stock price. Some common situations where traders face fear are:
After fear, GREED is the most common emotion that stock traders have to battle every day. In simple terms, it is a disproportionate desire for profits. This is a tricky emotion since traders are there in the market to make profits. So, how much profit is too much profit? If the markets are performing as per their expectations, then why should they exit the position? Why not continue holding the position and make more profits?
These are typical thoughts that GREED drives in our minds. This is more common if the markets are bullish and prices are rising. It pushes traders to hold on to winning positions much longer than advisable and throw caution to the winds. While optimism is good, there is a thin line between greed and optimism that each trader must identify and ensure that it is never crossed.
The only thing that separates stock trading from gambling is mindless HOPE. While ‘hope’ is a positive emotion, when it is not embedded in logic, it can lead to heavy losses.
Imagine purchasing a share since your analysis suggests that the price will increase during the day. After an initial hour of a surge, the stock price starts dropping. You are unable to understand the reason behind the drop in prices. This is when HOPE walks in and forces you to believe that if you hold on to your position for a little longer, the price will start increasing again and help you recover your losses.
Traders who don’t know how to control mindless HOPE tend to destroy their trading capital with a few wrong decisions. It stops them from cutting their losses and/or booking profits even when the markets are in their favor since they HOPE for more. If GREED attaches itself to HOPE, the results can be akin to gambling – disaster!
Let’s say that you plan to purchase stocks of ABC Limited since you think its price will increase during the day. At the last moment, you decide against it and hold back. Within an hour, the stock price rallies and doubles in value. This is where you start feeling REGRET.
WHAT IF I would have placed the trade? I missed out on a golden opportunity. I knew this was going to happen. Such thoughts cloud your mind and to make up for the lost opportunity, you might buy the stock at a double price after convincing yourself that the price will increase further. While this might seem like a logical decision at the time, it will be based on REGRET and not analysis. Hence, more often than not, you will find yourself on the losing side of the trade.
On the other hand, there might be a position that you might take even though you are not sure of it. Say that you are unsure about the price of ABC Limited rising but invest in it nonetheless since many experts are banking on it. As the day progresses, the stock price starts falling. This is another place where REGRET can step in making you sell the stock without analyzing its performance and potential recovery during the day.
While trading in stocks, it is important to remember that you will miss some opportunities or have a few bad trades. Accept this reality and calm your mind whenever you face any such event.
A term that gained popularity due to social media, FOMO has existed long before we even knew computers. FOMO is a social anxiety that starts from the thought that others are benefitting from an opportunity that you are missing out on. It is an anxiety that causes traders to take positions much after the window of opportunity has closed.
When you trade in stocks, it is important to remember that you will probably lose more trades than you win. While this might seem demotivating, once you understand and accept this possibility and create robust risk management to maximize your winnings and minimize your losses.
The emotions mentioned above can cause you to take trading decisions that might not be healthy for your portfolio. So, what do you do?
It all starts with identifying your emotional triggers and realizing how you react to them. For example, what do you do when you feel scared? Or, regret? Knowing your response to such negative emotions is the first step to managing them efficiently.
Trading is about backing your instincts. However, you must try to ensure that your instincts are rooted in facts and analysis. It is a thin line. Maintain a journal and identify trades where you allowed emotions to rule your decisions. Try to spot patterns and think about your frame of mind while placing such trades. It will help you curb such decisions in the future.
Creating a risk management plan is essential to ensure that you book profits and losses are predetermined levels without allowing hope or
Remember, a stock market is a volatile place. Also, it is impossible to predict the direction of movement of the price of any stock. While there are indicators that might suggest a specific trend, any external factor can reverse the trend in no time. Hence, it is important to keep an emotional balance and sound mental state to make strategic trading decisions.