Trading Psychology: A Beginner’s Guide

Although it gets most of the attention, mastering technical and fundamental analysis is only part of the equation. Understanding trading psychology is a crucial skill that separates successful traders from the rest.

Learning how to overcome trading fear, greed or bias is an essential skill you may need to develop as a trader. This article examines trading psychology in detail, how to improve it, and the emotions you should guard against when trading. 

What Is Trading Psychology

Trading psychology is the mental and emotional state you experience when trading. It refers to aspects of a trader’s behavior that influence the decision-making process when trading securities. 

Trading psychology is as important — if not more — than fundamental and technical analysis because emotions usually override logic.

The Basics of Trading Psychology

Understanding your trading psychology can be key to your performance as a trader. Let’s figure out several types of emotions you may experience in trading that you can manage to help improve your performance.

Greed

Greed is the temptation to behave irrationally in search of excessive profit. When a trader wants to buy more shares of a position that has performed well but doesn’t have the capital, leverage may provide the fuel to add positions. Borrowing money to take excessively large positions could be a sign of greed. Traders may also hold on to positions for too long in hopes of making more significant profits.

Fear

Trading fear refers to the anxiety caused by the possibility of loss, real or imagined. Traders might experience four types of fear: fear of missing out (FOMO), fear of loss, fear of being wrong, and fear of letting a win turn into a loss. You might close out a position too early or be too afraid to open a trade. 

Happiness

Joy, fulfillment, satisfaction, and contentment are indicators of happiness. But just like fear, happiness can cloud a trader's decision-making process. For example, you may be happy that a stock price is going up and stay in the stock, when this could be a cue for you to take a profit.

Anger

Anger is an intense emotional state you feel when a trade has gone wrong. It is characterized by feelings of stress, frustration and irritation. It might drive you to make a rash decision to exit a position early if you’re mad about its short-term performance, even if your strategy is long-term.

Pride

You can experience pride from repeated trading success. But this success could make you feel like you’re guaranteed to make money, blinding you to taking on an extra risk that could lead to losses.

Impatience

Impatience is the inability to wait, which usually appears as intolerance, irritability or restlessness. Impatient traders can feel frustrated and abandon carefully crafted plans. You might try to day trade a stock without a real plan instead of holding a position long-term.

Bias

Behavioral biases are subconscious ways of thinking that influence your actions in ways you may not be aware of. Here are some biases you should guard against as a trader.

Confirmation Bias

Confirmation bias is the tendency for traders to search for information that validates their trading strategy or plans. For example, a trader can disregard negative news about a company because they like the stock. 

Representative Bias

Representative bias occurs when a trader formulates the probability of an outcome based on the appearance of similarity of an object or event. An example is assuming that finance experts are the best source of information about a stock.

Status Quo Bias

When a trader believes that previous strategies will remain effective, this prejudice is known as the status quo bias. An example is the belief that stocks and bonds always move in opposite directions, as they have for the past few decades. 

Negativity Bias

Negativity bias means focusing on the downside of a trade rather than taking both sides (good and bad) into account.  You might assume that tech stocks are bad investments because of recent price declines while disregarding other factors that have impacted the sector like rate hikes or an impending recession.

Gambler's Fallacy

Commonly associated with gambling, this fallacy refers to a trader’s propensity to predict the outcome of a trade based on prior experiences without solid information to back up their claims. An example is assuming that bond yields would go higher because of rising rates irrespective of current economic conditions, like the possibility of a recession.

Anchoring Bias

Anchoring bias is a trading bias where you draw conclusions based on the first piece of information you encounter while disregarding subsequent information. If you bought Amazon.com Inc. before its stock split and owned it at $3,000, it might seem cheaper now that it’s trading at around $84.

Hindsight Bias

The tendency for people to claim that they "knew it all along" when the result of an event that was previously unclear becomes known is referred to as hindsight bias. An example would be claiming that you knew that oil prices would rise because of the Russia-Ukraine war.

Behavioral Finance

Behavioral finance is a mix of psychology and economics. It looks at how cognitive biases and emotions affect investor decisions and market results. Traditional finance believes markets are efficient and that investors act rationally. However, behavioral finance shows that there are patterns of irrational behavior. It studies concepts like overconfidence, loss aversion, and herd behavior. This field aims to uncover the psychological factors behind financial decisions. By understanding these factors, investors, financial professionals, and policymakers can make better choices. This can also help improve market efficiency. In this exploration of behavioral finance, we will discuss key concepts, theories, and practical implications that impact investor behavior and market dynamics.

Mental Accounting

Mental accounting is a concept from behavioral finance that explains how traders and investors sort their money into different categories, which can lead to illogical financial decisions. For example, a trader might focus more on short-term gains from a taxable brokerage account that is readily available, perceiving those profits as more valuable compared to long-term investments that could generate higher returns but are not immediately accessible. This mental bias might lead to less optimal decision-making, as traders could prioritize instant rewards over strategic long-term growth, ultimately impacting their overall investment results.

Herd Behavior

Herd behavior is when traders follow others instead of relying on their own analysis. It can happen in different ways. For example, traders might buy shares of a popular stock like GameStop Corp. simply because it is trending on social media. This is often not based on sound investment principles. The desire to join a collective movement can cloud judgment. This leads to impulsive decisions that might not match an investor's goals or risk tolerance. Consequently, herd behavior can create market bubbles and increase volatility. Traders may react to the same signals instead of conducting independent research.

Emotional Gap

The emotional gap refers to the disconnect between rational decision-making and strong emotions in trading. Traders can make impulsive decisions based on feelings like excitement, fear, anxiety, greed, or anger. For example, during a market rally, a trader might feel euphoria and invest heavily in riskier assets without evaluating the risks. In a market downturn, fear can trigger panic selling, leading traders to realize losses instead of holding for potential recovery. This emotional volatility can affect trading results. It often results in poor decisions that stray from a planned investment strategy. Recognizing and managing these emotions is essential for a disciplined trading approach.

Strategies to Improve Trading Psychology

After learning about the emotions and biases that affect trading psychology, you can use the following strategies to work on them. 

Identify Personality Traits

When actively trading, you can maintain awareness of individual personality traits that could impact decision-making. 

Research and Learn Continuously

Spend adequate time researching and learning about a security before investing. The market is always changing and so are the reactions of market participants.

Practice Through Paper Trading

Practice makes perfect, especially in trading. Paper trading gives you a chance to assess how you would react in certain situations and also refine your reactions and emotional responses.  

Develop a Trading Plan

A trading plan acts as a road map that outlines the objectives you hope to accomplish, your risk/reward profile and the trading approach you feel most comfortable with. You can visualize your trades, outline your decision-making approach and solidify your game plan.

Keep a Journal

Keeping a journal of your trades is a good way to keep your emotions in check while trading. A journal reminds you of why you entered a trade. 

Take a Break After Losses

When you take a series of losses, it is always advisable to take a break. Taking a break not only pauses the cycle of losses but also allows you to reflect on things you may have done wrong and how to approach your trades better. 

Master Your Emotions and the Market

Managing emotions is important for better trading results, especially when dealing with issues such as fear of missing out (FOMO), impulsive trades, and ignoring stop-losses. Emotional reactions can cause traders to make quick decisions that may lead to financial losses. By focusing on logical decision-making rather than emotional responses, traders can improve their risk management strategies and maintain discipline, particularly in unstable market conditions.

A good strategy is to establish clear trading rules and follow them, which helps keep emotions from influencing trade decisions. Staying disciplined enables traders to minimize losses early, avoiding small issues from turning into larger ones. On the flip side, letting profitable trades continue can result in higher earnings, supporting a disciplined trading approach.

Understanding and controlling emotions can reduce the risks associated with FOMO and hasty trading, allowing traders to base their decisions on logic instead of fear. By adopting discipline and good risk management practices, traders can operate in the market more effectively, resulting in improved trading results.

Frequently Asked Questions