Delving into Trading Psychology
How Your Brain Can Trick You in the Markets and What Can You Do About It
Trading in financial markets is the most challenging endeavor one may be up to. It can be exciting and rewarding, but it is a hell of a challenge!
Often, the biggest hurdle traders face isn’t the lack of fundamental knowledge or minimal technical skills, but their own minds.
Our brains can deceive us, leading to irrational decisions, and the inevitable vicious circle may lead to unexpected losses.
“The most important thing to do if you find yourself in a hole is to stop digging.”
- Warren Buffett
Let’s dive into the fascinating world of trading psychology and explore how our brains - sometimes - work against us, and what we can do about it.
Your Brain: Friend and Foe
Our brains are amazing at processing information and making quick decisions, skills that have helped humans thrive.
But in the world of trading, these same abilities can lead to mistakes. Here’s how:
1. Spotting Patterns That Aren’t There
Our brains are wired to find patterns. This is great for everyday life but not always in trading. Sometimes, we see patterns in random market data and make decisions based on these illusions.
This “illusion of control” can lead us to believe we can predict market movements when we really can’t.
2. Seeking Confirmation
Once we form an opinion about the market, we tend to look for information that supports it and ignore anything that contradicts it.
This is called confirmation bias and can make us stick to bad trades, hoping the market will turn around in our favor.
3. Hating to Lose
Losing hurts, and it hurts a lot more than winning feels good.
This loss aversion can make us hold onto losing trades for too long or take profits too early, just to avoid the pain of a potential loss.
4. Emotional Highs and Lows
Markets are volatile, and this can trigger strong emotions.
Fear can make us sell in a panic, while greed can lead us to take unnecessary risks. Managing these emotions is crucial for successful trading.
Great traders control both extremes of their emotion scale.
Common Cognitive Biases in Trading
Let’s look at a few common ways our thinking can go astray.
1. Anchoring
We often fixate on specific price points, like an asset’s previous high or low, and make decisions based on these anchors rather than current market conditions.
These sentences will give a clue about anchoring in action.
“Stocks have risen too far, they have to fall now!”
“Bitcoin is very cheap after this fall, I will earn a lot when it goes to new highs!”
… can you elaborate in the comments?
2. Hindsight Bias
After something happens, it’s easy to believe we saw it coming all along.
This hindsight bias can make us overconfident in our predictive abilities, leading to riskier trades.
After the move, it’s always obvious.
3. Recency Bias
We tend to give too much weight to recent events, believing recent trends will continue.
This bias can make us overlook the bigger picture and make short-sighted decisions.
I, as a day trader using only technical analysis, even look at the Monthly chart for key levels. It is easy to get lost in short-term trends if we don’t see the big picture.
4. Herding
Following the crowd can be tempting. If many traders are buying or selling an asset, we might feel pressured to do the same, often leading to irrational market moves.
Be ok with skipping moves. The market offers lots of opportunities.
Tips to Stay on Track
Knowing these psychological pitfalls is the first step to avoiding them. Here are some friendly tips to help you stay rational and focused:
1. Make a Trading Plan
Having a clear trading plan with entry and exit strategies, risk management rules, and profit targets can keep you grounded and prevent emotional decisions.
You only have to stick to that plan, and this is the hardest task for a beginner.
2. Keep a Trading Journal
Write down your trades and the reasons behind them.
Reviewing your journal can help you spot patterns in your behavior and improve your decision-making process.
3. Practice Mindfulness
Being aware of your emotions can help you avoid impulsive decisions.
Techniques like meditation and deep breathing can reduce stress and enhance your focus.
BREATHE!
Your breath is always with you… use it!
4. Keep Learning
The only thing permanent in the markets is the constant change.
Continuously learning about market developments can help you make better decisions.
Stay humble, stay open, stay flexible!
5. Manage Your Risk
Set strict risk management rules, like using stop-loss orders and not risking too much on a single trade.
This can help you stay calm and avoid making rash decisions.
Reduce your position size to a point where you enjoy trading! This is a fundamental rule every trader must understand!
Trading psychology is a crucial part of becoming a successful trader. Our brains are powerful, but they can also lead us astray.
By profoundly thinking about and understanding these psychological tendencies, and implementing strategies to combat them, you can make more rational and profitable trading decisions.
Stay aware, stay disciplined, and keep learning to overcome your mind’s tricky tendencies and achieve long-term success in the markets.