According to Investopedia, “Trading psychology refers to the emotions and mental state that help to dictate success or failure in trading securities. Trading psychology represents various aspects of an individual’s character and behaviors that influence their trading actions.” Apart from knowledge, experience, and skills, it’s well researched that emotions play a great role in managing trades and making money. Some of the common emotions that are associated and drive trading psychology include – fear, greed, hope, and regret. Containing emotions, thinking quickly, and exercising discipline come under the purview of trading psychology. Lets now look at some of the frequently faced emotions that affect trading:
1. FEAR
The Dictionary definition of fear is “a distressing emotion aroused by impending danger, evil, pain, etc. whether the threat is real or imagined; the feeling or condition of being afraid.” It’s important thus to focus on whether the threat is real or imagined. Most often in trading, the threat is imagined, and it leads the trader to make sub-optimal decisions. Traders thus need to understand what fear is and the different types of fears experienced while trading.
Some of the common trading fears include:
Fear of the unknown: It’s not easy to predict the losses that you may have to take or if the prices will swing in your favor. The best way to counter this fear especially for new traders is to be equipped with as much knowledge as possible about the markets by both taking courses as well as reading good trading books.
Fear of losses: Humans are afraid of losing and will go to great lengths to avoid losses. Though in order to avoid losses, traders often hesitate to cut losses or execute trades when the time comes. Rationally to handle this fear, traders must trade with money that they can afford to lose and also risk no more than 1% per trade.
Fear of giving back profits: Giving back profits is one of the greatest hurdles that a trader faces. Traders go to a great extent to protect the small profits in their trade, fearing it may turn to a loss. And the greater you’re past history of losses, the greater is the fear of giving back profits. Thus it’s important for traders to have a clear trading plan, which ensures they are more objective in trading than base it upon emotions.
As humans, its normal for traders to experience fear. However, they should ensure that it doesn’t cripple them while executing trades. Instead they should view the fear as a perceived threat and deal with them to push their trading to greater heights.
2. GREED
Greed is a natural emotion experienced by all human beings at varying degrees across their lifetime. In trading, however, greed as an emotion has proven to be a
hindrance than be of assistance to traders. Some of the Examples of greed when trading include ‘doubling down’ on losing trades, adding capital to winning
positions, and over-leveraging. However, like all emotions, it’s possible to control and overcome greed. It’s important that traders exercise discipline by sticking to
trading plans. Keeping a trading journal is yet another way to overcome the emotion of greed in trading.
3. REGRET
Whether it’s a missed opportunity or a wrong decision, trading can intensify the emotion of regret in many traders. Most traders have stories of trades they often
regret, however; regret can actually be used to improve trading. Developing mindfulness and observation by keeping a trading journal can help the trader note down the thoughts and notes of the trades as well as the reasons for opening and closing them. Careful examination of what went wrong with a trade can help traders create better strategies for future trades.
4. HOPE
Hope is the most dangerous emotion for traders blinding them to risks and giving a false sense of confidence. By holding on to hope traders add to losing positions
digging deeper holes that they should have climbed out of earlier. Hope along with pride in traders lead to the failure to acknowledge their wrongdoings and
correct them sooner. As wishing on the markets is not the best strategy, follow the markets and trade carefully.
Live Example
Lets look at a recent example where one could have made maximum profits by just following the rules and controlling ones emotions.
Reliance Industries made an inverted Head & shoulder Pattern in the first 6 months of 2020 (January – June). An inverted head & shoulder pattern is a strong
reversal pattern, which is found at the bottom of a down move. It is a strong bullish reversal pattern which is formed when price makes a new low, then a lower low followed by a higher low similar to the first one which looks like an upside down head with 2 shoulders.
When a stock forms this kind of pattern, we can place a long entry order above the neckline. The target is calculated by measuring the distance between the
head and the neckline and that is approximately the distance the price will move after it breaks the neckline.
Here the neckline is formed at 1600 levels and the head is formed around 870 levels, which when calculated gives a target of 730 points. In simple words if we
stick on to the rules and trade according to the principles we study in technical analysis, one could take a buy when reliance industries crosses above 1600 levels
and expect a target of 730 points from that point which makes our target 2330 keeping a stop loss below the neckline may be at 1560 levels.
As you can see from the charts the stock of reliance after breaking 1600 levels rallied up to 2360-2370 just within a short time span of 3 months after the
breakout. One could have easily made a fortune out of this stock as we are having a high-risk reward ratio. We are risking just 40 rupees for a target price of 730 RS
in a single stock.
Unfortunately when emotions start to control our trades, we can make a mess of the same trade. After initiating a buy from the breakout, if fear creeps in, a small
dip in the price will make the trader overreact and will lead him to sell of his positions with a small profit or even at loss, depending on where he has taken a
buy. As said in the beginning of our blog, they may avoid certain losses but here they are missing out huge gains.
Similarly, excessive desire of profits will make a trader hold on to the long position even after the final target has achieved, in our example the target price is
2330. Holding on to the stock above that price (a trader’s perspective not investors) or a fresh buy above that price is always risky, as the trend can reverse any time and the greedy will get slaughtered.
Idea & Concept: Ajith C J, Research Analyst (Technical & Derivatives)/Faculty
Content Development: Anju Kurian