Trading psychology — How do you deal with emotions as an investor?

Trading Psychology

Stock market crash or recovery? Was this the bottom or are we getting another dump? It is currently volatile and uncertain. Many traders and investors are looking at how to take advantage of the market in these exceptional circumstances, but it is also a great opportunity to take a closer look at the psychology of trading and investing.

Strongly fluctuating prices also lead to strong emotions. As far as I am concerned, there is no better time to reflect on how important it is to have your head in order.

For many investors, it is now important to be careful not to blindly follow the herd or react quickly to the volatility. Instead, take some time to think about the psychology of the market and your own pitfalls.

I am not an expert in psychology, but I have been around for a number of years. In addition to my personal mental battles, I have also read enough about this subject and therefore I think I can say something meaningful about it.

I’m not going to reinvent the wheel in this crash course.

Instead, I try to use sources of experts and my own experience to create something that every trader and investor can learn from.

So time to go deep, let’s go!

Investor psychology and market psychology

In this mini-course, we look at two aspects of psychology related to day traders and investors, namely:

• Investor Psychology
• Psychology of the market

The first is about you. How you can analyze and improve yourself to win more trades and not fall into the usual pitfalls. Think about:

• Having and keeping discipline
• Controlling your emotions
• Recognizing your own prejudices
• Making a trading plan that includes the above

The above things will mainly help you to become a better trader and ultimately also lay the foundation for understanding market psychology. This is what most of this mini-course is about.

So the second is market psychology, which I will cover in the last piece. This section will help you analyze the market.

This market psychology is also called behavioral finance. Think of it as an extension of an investor’s psychology. By recognizing the common pitfalls of individual traders, you will better understand the psychology of the market.

1. Why is psychology so important in trading and investing?

When it comes to day trading, it is usually about strategy and risk management. Where do I get in and out and how do I protect my capital?

But psychology is often neglected.

Experienced traders know the connection between psychology and their performance, but new investors often focus purely on strategy.

2. Controlling emotions through discipline

Without the discipline to stick to your own trading plan and rules, you can flicker the rest overboard too. Obviously, you first need a winning strategy or edge with a positive expectancy, but that’s not enough.

You will also need to control your emotions in order to carry out the rules of your plan properly over and over again.

In fact; I know traders with a profitable strategy who still manage to blow their accounts due to lack of discipline.

It works the other way around of course. If you don’t have a winning strategy or are unsure about your edge, you can still have so much discipline, but you won’t make it either.

You need both and one can’t do without the other.

But how do you build that self-confidence?

Gain confidence in your skills

The best way to gain confidence in your trading plan and strategy is to do it a lot, but of course not with real money. You can practice without risk with a demo account.

Some investors are a bit giggly about demo trading (or paper trading) and think it’s a far cry from the real deal. And yes, there are certainly differences, but in my opinion they do not outweigh the advantage that you can build trust without risk.

If you are unable to make a consistent profit on a demo account now, trading and investing may not be for you. Sounds harsh, but that could also be a conclusion. This game is not for everyone.

Once you have a winning strategy that works for you and set up a trading plan with fixed rules, the only thing holding you back is psychology.

Manage your risk

Too much leverage and too big positions are the biggest culprits that can fuck with your emotions. By managing your risk you protect both your financial and emotional capital.

• Are you awake from your trades?
• Do you continuously check your phone to see what your position is doing
• Are you getting out too early when a trade turns against you?

These are all signs that your position size is probably way too big.

Suppose you have a setup for a trade where you have a 99% chance of winning $ 100 per contract and 1% chance of losing $ 100 per contract.

How many contracts would you trade?

I don’t know about you, but I would be tempted to borrow as much as possible from my family, relatives, friends, friends of friends, and from my bank. Maybe I would liquidate my entire portfolio and kick everything into this one trade.

Still, you have to resist that temptation.

For the simple reason that there is a 1% chance that you will lose everything. If that happens you will of course never recover from it. You lost everything and now everyone gets money from you.

That is the essence of position sizing.

If your trades are too big you risk blowing up your account within a few losing trades and if they are too small you will leave money behind. From a psychological point of view it is therefore important to find a balance.

Patience is a virtue

Patient traders are disciplined traders. Those two really go hand in hand. If you want to jump right into investor psychology, you’ll have to learn to be patient.

Investors and traders are snipers. We are waiting in the bushes for the ultimate setup. Everything has to coincide before we pull the trigger. And if it doesn’t coincide, we’ll go home and try again tomorrow.

This is a difficult one for many people, because it is very easy to convince yourself that trade is good enough even though it does not comply 100% with your rules.

Then you pull the trigger anyway and before you know it you are madly scouring the internet for news that validates your decision.

Recognizable?

Things that can help with this are:

• A checklist for your specific entry rules, which you physically tick before opening a trade.
• Keeping a trading journal.
• Mindfulness exercises, where you accept that you have no control over the market, that you do not have to force it and that waiting is an essential part of successful investing.

3. Dealing with extreme outcomes

Psychology naturally comes to the fore in extreme situations and for traders and investors the two most important are winning and losing.

Multiple losses in a row

These are also called losing streaks and sooner or later every trader will have to deal with this. Some investors are drawn into a negative spiral and others come out with fresh courage and new insights.

In my article losing is part of trading and investing I will discuss this in more detail.

Negative spiral of a trader

Winning streaks and success

It seems clear to me that this is a luxury problem and easier to deal with than losses, but there are also pitfalls here. I think it’s important to also prepare your head for success and making money.

Gambling and participating in the lottery cannot be compared to trading and investing one on one, but stories of jackpot winners show that you also need to have a plan for success and a lot of money.

This not only applies to the financial picture, but also to your mindset. Once you have a successful edge, things can go quickly and that is something you should take into account, I think.

If everything suddenly succeeds, you run the following risks:

• Arrogance and thinking that you are better than the rest
  Feeling that you made it and stop learning
• Turning into yourself and not wanting to share
• Becoming lazy and at risk of excesses (alcohol, drugs, women)

What has helped me is that I always keep looking for people who are further than me. Not only in the field of trading, but also in other areas. In addition, I have started sharing my knowledge, which forces me to continue learning.

And I have a few so-called “brag buddies” who are on about the same level, with whom I can spar and share successes. Not everyone understands what I do and then it is nice to have some people who understand.

4. Known pitfalls

Everyone has personal weaknesses that you will have to identify and work on yourself, but there are also pitfalls that apply to almost everyone.

The sooner you recognize these obstacles, the sooner you can deal with them. Below you will find my list.

Not being able to switch and put your ego aside

The funny thing is that many bright minds and successful professionals from other fields often fail as traders. That’s because trading requires a shift in your mindset that most people can’t handle.

Trading and investing differs from everything else in that you have to put your ego aside and think in terms of probabilities. And that’s fucking hard when your hard-earned money is at stake.

As traders, we try to spot opportunities in the chaos where outcome A has a higher probability than outcome B.

And if we get it right a little more often than wrong and win more on our winners than we lose on our losers, we make money.

So it is not about always being right and winning everything, but about speculation and risk management. That is completely unnatural for many people in terms of character and (how ironic!) It is often precisely the people with a large ego who are interested in trading.

The Eternal Quest

Another one that will be recognizable for many traders. Hopping from one strategy to another. Always looking for something new and something better. New strategies, new software, new indicators, signal services, etc.

Believe me; less is more. Not only in terms of stuff on your charts, but also in terms of strategy and entry criteria. You can be profitable with the simplest trading strategy and I trade completely without indicators. Purely on price action.

The holy grail is not a new indicator. It is a combination of an edge, risk management and psychology.

Ignoring personal bias

Everyone has constant prejudices about anything and everything, but we usually don’t realize it. Those prejudices (or bias) are very sneaky and influence many of our decisions. Something that is not always useful when trading or investing.

Just by watching the news or following certain people via social media you create benefits that determine your view of the market. That may be fine, but in most cases it will only get in the way of your trading plan.

Gathering news and forming an opinion is fine, but your opinion does not determine what the market will do.

Always keep an open mind.

The danger of small accounts

You might not have expected this immediately, but it is a phenomenon that I see more and more now that the minimum deposit at brokers is getting lower. Nowadays you can already invest with € 10. That sounds nice of course, but it is not convenient.

Here are some tips for traders who want to start with a small account:

• Adjust your position size to your account size
• First, focus on not losing and protecting your capital instead of winning
• Think of it as a challenge or underdog position that you have little capital.
• Get the strength that you have to do your best
• Try to increase your trading capital by saving
• Only trade with money you can afford to lose
• Be careful with leverage
• Be realistic. A small account just means small profits

5. Practical tips for your mindset

In the previous chapters, the emphasis was mainly on how to think like a trader and the mindset that goes with it. In this section, we will look at what you can do in concrete terms to improve your trading psychology.

Record everything in a trading journal

With a good trading journal in which you systematically keep track of everything you do, you force yourself to look back and reflect. That way you can recognize patterns on your losing trades on which you can then adjust and improve your strategy.

This gives a lot of peace and insight, which is good for your mindset. Trading is a business and a healthy business requires healthy administration.

Meditation and clearing your mind

I am super down to earth and always thought meditation was a bit cloudy, but since I started it (keep an open mind!) It has only helped me.

Besides that it gives me peace and relaxation, I also feel that I have more space in my head. It also makes me more aware of my thoughts and relieves stress.

Again it’s not for everyone but I dare you to give it a try. I use the free Insight Timer app.

If meditation is not for you at all, then exercising is a great alternative. You also clear your head in a sense with activities such as running, cycling, kickboxing or swimming.

It is best to do both. A healthy mind in a healthy body makes a killer trading machine!

Continue to learn and renounce bad habits

Step one, of course, is to become aware of your emotions and prejudices. Only then can you recognize your own bad habits. Step two is find a way to break those bad habits.

The best way to do that is to keep tackling a single bad habit.

Examples of bad trading habits are:

• Revenge trading (opening new trades out of revenge or anger to win back your money after a loser)
• Overtrading (having no patience, trading for the rush of gambling)
• Not following your own trading rules (rationalizing mistakes, just talking to yourself, no discipline)

Every habit has a trigger, action and reward. For example, in case of overtraining:

• Trigger: The market is rising with a lot of volatility
• Action: You click on the buy button on the autopilot
• Reward: You get a mental high from the chance to win money

Good habits also have a trigger, action and reward. For example, having patience:

• Trigger: The market hardly moves
• Action: You turn off your laptop and go fishing
• Reward: You enjoy the freedom you have as a trader

It’s hard to spot those bad habits in yourself. That is why it can be useful to gather some trading friends around you who can point it out to you.

Example

Let’s take as an example that your bad habit is that you set your stop loss to break even too early.

Why is this bad trading practice?

It ensures that you are stuck on trades that could have ended up being profitable if you had left more room. You avoid the temporary negative feeling of a losing trade. But your profitability will suffer in the long run if you are kept out too early.

The tightening of your stop loss is a reaction to the market that moves against your position. You will be rewarded with the feeling that you are not a loser. So…

• Trigger: The market is moving in the wrong direction
• Action: You set your stop loss to break even
• Reward: You avoid the feeling of losing

When trading and investing, the reward for bad habits is often not financial or physical. It is a rewarding feeling or emotion that your brain enjoys.

Because of the reward you get, you develop a desire that strengthens the habit. Therefore, the key to renouncing bad habits is to identify the desire and turn it into something else.

In that sense, breaking a bad habit means replacing it with a good one.

We take the above example again. We keep the trigger and reward, but exchange the action for something else.

• Trigger: The market is moving in the wrong direction
• Action: Step back and look at the reasons why you took this trade
• Reward: You avoid the feeling of losing

Your brain longs to avoid feeling like a loser. Don’t try to counteract that desire. Instead, come up with a healthy method to still get the reward your brain asks for. And in this case, it’s to avoid feeling like a loser.

Reviewing your original reasons for opening that position is a good substitute. It reminds you of the valid reasons you had for choosing this trade. In trading and investing, the outcome of a single trade is not interesting at all. It is a game of chance, where the process and the final statistics are much more important.

And since you have damn good reasons to make this trade, you’re a winner anyway!

This will strengthen your confidence in your position and it will also help you resist the temptation to mess around with it by shifting the stop loss.

In practice, redirecting your desire is easier said than done.

A useful method is to take a short break. As soon as you feel the desire, pause for a moment before responding. In this way you disrupt the pace at which habits normally play out. This gives you the space to become aware that you can do something about it.

6. Market psychology

We have arrived at the last part of this mini course, where I want to zoom in on the collective psychology of the market.

After confronting your emotions, prejudices, and bad habits, you discover that you are anything but an objective or unemotional player in the marketplace.

Good, you are not alone! 😉

The market is made up of other traders and investors, all of whom have their own prejudices, emotions and habits. This is also in line with the efficient market hypothesis. And the field of behavioral finance actually originated by trying to unite the market with all its irrational players into a whole that you can also analyze collectively.

See below the cycle of emotions of the market as a whole.

Market Psychology Cyclus

It goes too far to elaborate on the psychology of the market or the collective. If you want to read more about that, look for books on crowd psychology and mob mentality.

Finally

This story is of course not as sexy as a nice article about a new strategy, but as I said at the beginning, I think this is really a very important aspect. In my opinion, becoming the boss of your own emotions, prejudices and habits is necessary to survive this game, let alone win consistently.

These are the three ingredients:

• Become aware of your emotions, prejudices and habits
• Build up experience in trading and investing
• Recognizing your feelings and actions when making financial decisions

This crash course is mainly to help you with number one on this list. Now it is up to you to gain practical experience. Keep in mind the ideas you have gained here while trading. You will see that it is going to help you.