Trading Psychology: Biases, Discipline & Risk Management

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 our psychology in trading lesson.

What is Trading Psychology?

Psychology is the study of mind and behaviour. 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 being 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 who have better control over their feelings and emotions tend to make more logical decisions as compared to those who follow their ‘feelings’.

Emotional Biases vs Cognitive Biases

Trading psychology involves successfully managing diverse emotional and cognitive biases that usually distort decision-making, lead to irrational and impulsive trades, and often result in poor financial outcomes. Let’s examine both these biases in more detail below. 

Major Cognitive Biases: 

• Confirmation Bias: Looking for information that backs pre-existing beliefs/feelings while neglecting contrary information. 
• Anchoring Bias: Depending excessively on the first piece of data, i.e. purchase price or other data points, when making decisions. 
• Overconfidence Bias: Overestimating personal ability to forecast market movements. 
• Recency Bias: Overvaluing any recent events, i.e. any major spike or crash in the market, over long-term trends. 
• Familiarity Bias: Investing solely in familiar assets and reducing diversification. 

Major Emotional Biases: 

• Loss Aversion: The tendency to try to avoid losses rather than acquire any equivalent gains. It often leads investors to hold on to losing positions too long. 
• Fear of Missing Out (FOMO): The fear of missing out often leads to irrational and impulsive decisions due to anxiety about missing potential opportunities to earn profits. 
• Revenge Trading: This is trading immediately after a loss to make up for the same, usually driven by anger. 
• Overconfidence/Greed: Taking on excessive risks to pursue high returns, often disregarding proper strategies for risk management.

Some Prominent Emotions Faced by Stock Traders

While we experience a range of emotions on any given day, there are some prominent ones that affect trader psychology that we would like to talk about today.

Fear

One of the first emotions that comes 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 instils fear in the mind of the traders and causes them to make sudden decisions to square 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 stock market psychology fear are-

• Not initiating a trade due to the fear of not getting it right
• Not selling a losing trade since they have to book the loss and the possible potential of recovering losses if the price starts increasing
• Selling too soon due to the fear of losing profits, etc.

Greed

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.

You may also want to know the 5 Best Ways to Overcome Stock Market Fear

Hope

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 favour since they HOPE for more. If GREED attaches itself to HOPE, the results can be akin to gambling – disaster!

Regret

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.

Fear of Missing Out (FOMO)

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. 

Ego

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 make trading decisions that might not be healthy for your portfolio. So, what do you do? 

Common Biases 

Here is a guide to some of the common biases that you will encounter among investors in the market. 

• Hindsight Bias: Suppose you persuade yourself that a market move was quite predictable after it happened, thereby leading to overconfident predictions in the future. 
• Regret Aversion: You avoid making any decisions to prevent any possible regret, i.e. not selling a losing stock since it means you’ll have to accept an actual loss. 
• Herd Behaviour: Indian retail investors often end up following the market experts or the actions of the majority. They buy into rallies and often sell in panic without even examining the fundamentals closely. 

How to Curb Emotion-driven Trading Decisions?

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 allow 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 at predetermined levels without allowing hope or 

The Psychological Side of Risk Management

You’ll find that risk management is often psychological and not just numerical. Here’s how: 

• Fear often overrides logic: The biggest obstacle in the Indian markets (BSE/NSE) is the fear of booking any loss. You know where to exit numerically, but psychologically, you’ll keep hoping it eventually turns around. This may sometimes transform a small loss into a huge one. 
• Over-leverage and sheer greed: Many traders are driven primarily by greed to use over-leverage. The psychological desire to earn a quick buck often obscures the numerical reality that high leverage increases the probability of eroding your capital. 
• Revenge trading: After a loss, the psychology of trying to win it back may lead to impulsive, revenge trading while neglecting predefined risk management rules. 
• Impulse versus discipline: Written plans/blueprints are numerical, although following them necessitates mental discipline when the markets are volatile. 

Some of the major psychological shifts include the following (for risk management): 

• Accepting losses: You should view a stop-loss as a business expense and not a failure. 
• Consistency over intensity: Focusing more on small and steady wins instead of gambling for a single and big profit. 
• Detaching from the outcomes: Being traded well means following your blueprint, even when the trade is a loss. This ensures profitability in the long term.

Position sizing

Position sizing is often the main answer to the classic fallacy of the gambler, i.e. the wrongful belief that a win is more likely with consecutive losses. By restricting exposure to 1-2% of capital per trade, traders usually eliminate emotional pressure to recover losses, thereby preventing revenge trading and potential mega losses.

Here are some key aspects to note in this regard - 

• Combating the recovery mindset: Traders facing back-to-back losses often scale up their bet sizes, mistakenly believing a win is due. This frequently destroys trading accounts, while fixed and small position sizing ensures that a single loss is not a widespread disaster, and only data. 
• The 1% rule: A commonly recommended blueprint is to restrict the maximum loss to 1% of the total capital on any one trade. 
• Emotional regulation: Controlled position sizing helps keep a survival brain more in check. When the positions are excessively large, regular volatility may feel dangerous, leading to emotional and irrational decision-making. 
• Preventing revenge trading: If you lose about 3% of your account in one day, stop trading instantly. 

Building a Consistent Trading Journal Habit

Here is a sample trading journal structure you can consider (should record both psychological state and technical data), including the vital fields to log. 

• Trade Details: Instrument (Nifty/Bank Nifty), Date, Entry/Exit Price, Direction, Trade Size
• Psychological State: Emotional state before (examples- fearful, confident), during (patient or panicked) and after (regretful or relieved) the trade
• Rationale: Why the trade was done (technical setup)
• Trade Management: Was the stop-loss/target strategy followed? 
• Performance Grade: Grading the trade quality (A+ for perfectly complying with the rules, C for impulsive moves)

The review routine can be the following: 

• Daily: Review your emotional state and daily execution. Always ask yourself - “Did I follow my original plan?”, and also “Was my exit based on my strategy or fear?” 
• Weekly: Analyse the patterns in the journal, including the time of day when you make the worst or best trades and whether you are continually overtrading any particular instrument. 
• Psychological auditing: Identify the key emotions, i.e. fear, greed, FOMO, etc., which are causing the biggest losses. 

Building Discipline Across Every Stage of a Trade

Here’s how you can build discipline in the key before, during and after phases of trades. 

Before the Trade (Pre-Market Discipline): 

• Creating a written trading plan with particular exit and entry criteria. 
• Spending 10-15 minutes analysing the news and setting up scenarios for the day to bypass impulsive decision-making. 
• Setting the maximum loss for the day in advance. If you hit this, stop trading instantly. 
• Use meditation or visualisation to calm yourself and lower anxiety. 

During the Trade (Discipline Maintenance): 

• Respecting Stop-Losses: Do not remove a stop-loss to let the losing trade keep running. 
• Bypass Revenge Trading: Do not attempt to recover a loss instantly by getting into another trade. 
• Managing Screen Time: Excessively tracking candles will only lead to more anxiety and possibly poor decision-making. Only look at the screen when you have to take action. 
• Procedure Over the Outcomes: Focus only on following your own system, not on the money you lose or make. 

After the Trade (Post-Market Discipline): 

• Journaling the Daily Happenings: Record why you entered any trade, your feelings and the outcome. This will reveal your own emotional biases and weaknesses. 
• Take a Break: After a major win or loss, take some time to reset and avoid emotional overconfidence or fear. 
• Analyse Your Mistakes: Identify whether you violated your own system or rules. Make a plan to avoid the same on the next day. 
• Reflect on Your Decisions: Ask yourself, “Would I go for this trade if I had not just lost or won the last one?” 

How To Handle a Losing Streak

Here’s what you can do after a losing streak while trading: 

• Step away and pause: Don’t try to recover your losses instantly. Take a break and step away from the screen. 
• Evaluate your journal: Review the last 5-10 trades to understand whether you broke your rules or whether there was any change in the market conditions. 
• Lower the position size: Cut your trading size to 25% or even 50% of the normal for better risk management. This ensures that you don’t end up eroding your account during any drawdown. 
• Build your confidence steadily again: Take just the highest probability trading setups and base hits. Don’t aim to score big right away to recover the losses. 
• Check whether your strategy is valid: Examine whether it is currently suitable for market trends or in a natural, temporary drawdown period. 
• Accept the losses: Losing is part of trading, not your personal failure. You should learn to accept it. 
• Look for community support: Link up with other traders to lower the emotional stress. 

How a Pre-Trade Checklist Improves Decision-Making

Here is a checklist that you can follow before entering a trade - 

Post-Trade Review and Journal Template

Here is a sample journal template you can use after your trades: 

Understanding Maximum Risk Per Trade

Let us consider an example to understand max-risk-per-trade: 

Let’s assume the total trading capital is ₹1,00,000. In this case, the maximum risk percentage is 1% per trade.

Hence, the maximum risk amount is -

1% X ₹ 1,00,000 = ₹1,000

Now, let’s say you wish to purchase stocks of Company XYZ at ₹900 with a stop-loss set at ₹890. Hence, the risk per share is -

₹900 - ₹890 = ₹10

You can buy 100 shares. If the stop-loss hits, you will lose exactly ₹1,000 (1% of your capital). Also, for every ₹1,000 you risk, you aim for a profit of ₹2,000, i.e., a risk-reward ratio of at least 1:2. 

Understanding Revenge Trading and Rule-Based Trading

Let us now understand revenge trading and rule-based trading with an example. Assume that you purchased 100 shares of Company ABC at ₹500, hoping for a breakout. It then comes down to ₹490, hitting the stop-loss and leading to a loss of ₹1,000. 

Revenge Trading:

Out of anger and sheer frustration, you instantly purchase 200 shares of the company (doubling your position size) at ₹490, hoping to recover your ₹1,000 quickly.

Now, Company X drops once again to ₹480, meaning that you now have a ₹2,000 loss on the second trade, along with a loss of ₹1,000 on the first one.

This results in a total loss of ₹3,000. 

Rule-Based Trading: 

You feel that the trade did not meet your conditions and accept the pre-set loss accordingly.

You take the ₹1,000 loss per the original trading blueprint, close the screen, and calmly review the chart.

You find that another stock offers a more valid, high-probability setup, depending on your blueprint. 

Psychology Operating System

Let’s look at a psychology operating system that could be implemented to improve outcomes (for the NSE/BSE). 

Summing Up

Remember, the 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.