Phycology in trading

  • Sep 08 2022
  • by
  • Analyst AZA
Phycology in trading

Psychological aspects that affect traders and how they can be overcome

Day trading can provide a trader with desirable rewards and large potential risks. Traders need to be thoughtful of the risks and be willing to accept them to participate in the financial markets. First, it is advised to not trade with the capital that you cannot afford to lose. Secondly, learn about something before putting money into it. Imagine 2 traders, we will refer to them as Brad and Joe. Both Brad and Joe buy a book on their favourite subject, read it, and acquire a strategy for day trading the forex market. Both of them have the same amount of experience in the market and if they were to take an IQ test, they would be equal. After reading the trading book, both of them decide to take to the market. They use the strategy they both learnt to the best of their ability.

They are trading the same currency pair, on the same days, and they look for the same entries and exits, which means they are executing trades at the same time. Everything about Brad and Joe is the same, including their trading environment. After a month of trading the same strategy, they arrange a meeting to compare their outcomes. As they compare their results, they realise that Brad was highly profitable and Joe was not. How can this be? the answer is simple "execution". In other words, Brad can execute better than Joe. Both Brad and Joe knew what to do, but Brad was good at doing it. Joe's circumstance is not unique to him and most traders fall victim to this predicament. Unfortunately for us humans, we are not very good at making good choices, but we can get better. That's what this article is about, getting better at making good choices.

Fear and greed are the main factors that result in traders blowing their accounts. It's unusual to find a trader who has not experienced fear and greed while trading the markets. Most trading books and mentors will advise the banishing of fear and greed for one to be successful. This article will show traders how to use those emotions to their favour to be profitable instead of banishing them. This article won't be explaining typical psychological trading concepts but will seek to explain the root of our psychological make-up. Knowing how our brain was designed after many years of evolution will allow us to be able to use our bad traits to our advantage. Fear has helped the early human civilization to survive against wild animals and against losing our lives. In trading, fear can result in a trader losing money.

Most traders have cut their winners short in fear of price erasing their winning open positions. Sometimes traders would refrain from taking a good trading opportunity because of fear of losing money. Losing also comes in a form of letting good opportunities pass you by. As a trader myself, I have realised that as you let good opportunities pass you by, you will try to make up for the lost opportunities by over-leveraging your future trades. For traders to take full control of their trade execution, they have to overcome some challenges. The challenges consist of fear, greed, cognitive bias, and learnt behaviour. When all of these challenges are conquered a trader can reach a level of self-actualization. The factors mentioned above influence most of our decision-making processes. Greed and fear are the factors that are the most difficult to overcome. Therefore, rather than trying to overcome fear and greed, we will subject our energy to overcoming cognitive bias and learnt behaviour.

Optimism bias is when a trader is overconfident about his abilities or his strategies. This makes a trader unrealistic about the challenges that are present in trading the financial markets. The optimism bias is like a spam folder in our email, it intersects the data that we don't like and remove it before it can get registered in our conscious mind. This bias is a problem for traders because as traders we depend on data and charts to base our trading decisions, but if our brains are filtering out things we don't desire to see (when it is not accepting bad news) then we won't see the full picture. When we have an open position that is trading against us, we will tend to ignore the indications that it's time to exit the trade. Rather than getting out of the position, we will focus on anything (no matter how small) that gives us the reason to keep the position open.

Confirmation bias is the other side of the optimism bias coin, but instead of rejecting bad news confirmation bias boost positive news. For example, we are testing a new strategy we learnt, we execute 20 trades, 16 are losers and 4 are winners. A trader who has an optimism bias will take the smaller wins to heart and reject the losers. How can we protect ourselves from falling victim to this bias? the most useful method is to turn the charts upside down. You can turn the laptop or phone upside down or you can do it mentally. Here is an example closer to home, imagine you get a perfect set up to buy a certain currency pair, you open the position but the market moves in contrast to what the strategy suggested. That means we should exit since losers are an integral part of trading. The confirmation bias will blind us to the signs that the position is trading against us. Turning the chart upside down will confuse the bias. The brain will look for every reason to keep us in the trade, but after turning the charts upside down it will be tricked.

Illusory correlation occurs when traders attach mystical powers to their trading performance. This is natural a broad-based phenomenon, and traders are no exception. Illusory correlations are a very disadvantage to the trader because they a subsequently fuelled by the biases mentioned above. After having a very rewarding trade, traders tend to look for reasons that made that particular trade special, even if it was pure luck, and they will likely use more leverage in the future. This suppresses reasoning and puts more emphasis on mystical forces. Traders should incorporate the use of a trading journal into their trading. The journal should be used to record everyday performance. The summary of the day's performance should include the name of the currency pair that was traded, how it was traded, the position size, and how the trade transpired. Traders need to note the mistakes they did in every trade. This will help the trader not to repeat the same mistakes.

Over-trading can serve as a hindrance to trading successfully. Traders should prioritise time management, and seek to trade for a predetermined time. When we overtrade, we tend to be emotional about our trades. Today's technology allows trades to set stop loss and target profits, rather than spending most of the time on the screen. I advise traders to take short breaks between trading sessions to refresh their minds. You can go to a park on just starting a garden. Remember, Trading is an organised game played in an organised arena.

Thanks, and good luck.

Both Brad and Joe buy a book on their favourite subject, read it, and acquire a strategy for day trading the forex market.


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