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Essentials Of Trading Psychology

This is a discussion on Essentials Of Trading Psychology within thePsychology, Risk & Money Management forums, part of the Methodscategory; What are ‘Essentials’ Stickies? Welcome to the Essentials ofPsychology Sticky. Stickies are threads that are ‘stuck’ to the top ...

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Dec 14, 2012, 1:55pm #1

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808 PostsJoined Dec 2004

Essentials Of Trading Psychology

What are ‘Essentials’ Stickies?Welcome to the Essentials of Psychology Sticky.Stickies are threads that are ‘stuck’ to the topof a forum index. They contain informationabout the forum you’re in that is of critical orongoing value - hence the ‘Essentials’ name. Ifthere is anything missing from this ‘Essentials’Sticky, or if there is content that is incorrect ormisleading, please contact timsk, T2W ContentManager and, all being well, it will beamended.

Trading Psychology – What’s it all about? -Post #2If you’re new to trading, you’ll doubtless bejumping from pillar to post trying to absorb asmuch as you can about this business, beforedeciding if it’s right for you. Whichever site yousurf, book you read or trader you talk to, therewill be one subject that crops up time and timeagain: trader psychology. What’s it all aboutand why is it such a big deal?

First of all, let’s clarify what is meant by theterm ‘trader psychology’. Wikipedia defines‘psychology’ as an “academic and applieddiscipline that involves the scientific study ofmental functions and behaviours”. There arethree mental functions and behaviours thatapply specifically to traders: confidence,discipline and emotions.

In the next post we’ll examine each one indetail and why your ability to deal with them isvital to your success. If you don’t keep them incheck, then you can kiss goodbye to a goodnight’s sleep, your glorious head of hair –assuming you have one - and those perfectlymanicured fingernails. Oh, another thing

you’re likely to kiss goodbye to is your tradingaccount. Afraid so. If any one of these threemental functions and behaviors are allowed torun riot, then a ‘blow up’ (traders’ jargon forlosing most or all of their account) is all butinevitable.

Other Resources on T2W & Beyond - Post #3There are some great resources regardingpsychology beyond the walls of this forum. Inpost #3, you will find useful links to other areasof T2W and beyond, with a short précis abouteach one.

Dec 14, 2012, 1:56pm #2

T2W Bot

808 PostsJoined Dec 2004

Trading Psychology – What’s it all about?

If you’ve read any other Stickies or FAQs onT2W, you’ll have gathered by now that thereare very few absolutes in trading. In otherwords, there are very few things about whichmost traders – let alone all traders - agree. Onesuch absolute is trader psychology. If yourhead is in the wrong place, the chances of youscrewing up increases exponentially.Ultimately, screwing up tends to result in oneor two things, sometimes both: failing torealise a profit and/or taking a loss. (Pleasenote that losing trades are not necessarily‘screw ups’ and, by the same token, it’spossible to make a right pig’s ear of things andstill exit a trade with a profit.) Then there’s thequestion of scale. Minor screw ups are to beexpected, especially amongst novices. Theseare fine, necessary even, to teach the traderimportant lessons about themselves and aboutthe markets. Major screw ups are bestavoided, not least because few traders canafford to have very many of them. The goal ofthis Sticky is to equip you with the basicinformation required to ensure that all yourfuture screw ups are minor learning

experiences, not major disasters from whichyou may never recover. To achieve that, let’sstart with the first of the three mentalfunctions and behaviours mentioned in theopening post: confidence.

ConfidenceAs a trader, you are engaging in a performanceactivity. In this respect, you are in the samearena as actors, musicians, athletes and othersports men and women. Top sports stars haveto have confidence in their abilities. Watch anysport, whether it’s a team game like football oran individual game like tennis and you canusually see who’s playing with confidence andwho isn’t. In the final stages of the Wimbledontennis championships, you will often hearcommentators say things like: ‘S/he’s having todig deep to find the winning shots when it reallymatters’ or ‘It’s all about who wants it the most’.The point is that, arguably, there isn’t muchdifference in terms of sheer ability betweenthe top 10 players in the world. Yet, Federer,Dvocovic and Nadal repeatedly divvy out themajor trophies between them. To a greater orlesser extent, what separates these threechampions from the other seven top ten menis confidence.

As a trader, especially when you’re starting out,you’re competing against professionals at thetop of their game - right from day one. Thereare no junior markets where you can practiceand gradually work your way up to the seniorcircuit. There is no ‘newbie friendly’kindergarten market where your broker willgive you your money back if everything goespear shaped. The best you can do is to papertrade on a demo account and, when you makethe transition to trading real money, starttrading with the smallest size possible. It isoften said that the worst thing that can happento a novice trader is that they start on awinning streak. If you took up tennis and, onlyhaving played the game for a few months,

somehow found yourself in a competitivematch against Federer – you would lose. That’sa no-brainer, obviously. The only way youcould possibly win would be if Federersustained an injury and retired. Ironically, thesame thing does not apply to trading. You canwin from the get go and then you’re likely tosuffer from the one thing that’s even worsethan having no confidence at all – beingover-confident. Make no mistake, the minuteyou start to think you’ve got the marketssussed and it’s just one great big personal ATMmachine, you’ll get your ar$e handed to you ona plate. And that comes with an official T2Wguarantee!

So, what is required then is balance;confidence without being over-confident,based on knowledge, acquired skills andexperience. Hollywood actors can fluff theirlines, famous musicians can hit bum notes andpro’ footballers can score own goals. However,whilst all these things can and do happen,most top performers in these professions areconfident that they’ll do well most of the time,based on their training and dedication to theircraft. And so it is with traders. However, unlessyou’re taken on by a bank or proprietarytrading firm, getting to the stage at which youcan justifiably be confident in your ownabilities is likely to take longer than you think.Much longer. To be able to consistently takeprofits out of the markets over the medium tolong term as a retail trader, is akin to taking upacting with the view to making a living doing it.It could happen, but probably not overnight.Or learning to play the guitar with the view tobecoming session musician. Or taking upfootball with the aim of playing for a team as asalaried player. Some people will say thattrading really isn’t as difficult as any of theabove. Maybe they’re right. However, one thingis for sure. Most novice traders start off bybeing over confident, fuelled by hope andfantasy, without any real idea of the scale of

the challenge that lies ahead of them. Havingread this far, you no longer have that excuse.

Gaining confidence is a slow process and willreflect the time and effort you put in toacquiring the necessary knowledge and honingyour trading skills. To do this efficiently, youwill need to structure your learning. Thinkabout the top musicians and sports men andwomen mentioned earlier. To a greater orlesser extent, the quality of their performancewhen they’re under the spotlight is dictated bythe study and practice they put in when they’reaway from it. That study and practice isn’tarbitrary or random; it’s highly organised. Youmust try and manage yourself with the samesort of mindset that a great manager like AlexFerguson uses to manage Manchester United.Brett Steenbarger refers to this as being‘process-driven’. To acquire real confidence,based on true ability, you’ll need to becomeprocess-driven. Here’s how he explains it:“Sports teams practice their plays again andagain so that they can execute automatically andflawlessly in games. A surgeon has a research-tested process for conducting a delicate surgery;an artist has a process for training an apprentice.When traders are process-focused and process-driven, random needs, impulses, emotions, etc.are less likely to interfere with trading. Equallyimportant, the process can ensure that tradersare as consistent as possible in doing what theydo best.”

DisciplineConfidence in ones abilities is the result ofacquired knowledge and practical applicationof skills and experience. It takes time and lotsof hard work to acquire. Even if you have goodreason to be confident in your trading abilities,on its own, it’s not sufficient to ensure successin the markets. You need more. You needdiscipline. The good news here is thatdiscipline is easier and faster to acquire.Indeed, you may already be a disciplined

person and just need a few pointers abouthow to apply it to the markets. The bad news isthat many traders fall at this hurdle, as itproves much harder to master than many ofthem imagine.

On paper, trading with discipline isstraightforward. It’s simply a case of knowingwhat to do at any given time and then doing it.Or knowing what not to do and not doing it, asthe case may be. To achieve this, you musthave a trading plan that details everythingrelating to your trading life. Whatever themarkets throw at you, you never want to becaught like the proverbial rabbit, frozen,starring into the headlights. Expect the worstand plan for it. Your trading plan will detailexactly what your edge is, how to trade it welland the positive expectancy that you’ll enjoywhen you do. (For an explanation of the terms‘edge’ and ‘positive expectancy’, please refer tothe FAQ Essentials Of 'First Steps' ) Thechallenge then is to trade your plan day afterday, week after week, month after month. Thatain’t easy. Somehow, amidst the highs andlows of daily life, you have to trade your planconsistently and methodically. All the while themarkets, i.e. the people on the other side ofyour trades, are doing their utmost to part youfrom your money. This is one of the reasonswhy some discretionary traders turn tomechanical trading systems, as computers area bit more level headed and consistent in theirapproach than their human operators.

Let’s return briefly to the tennis analogy. Thecommentators love their match statistics and,in the interval between games or at the end ofthe set, they look at the key stats of thecompetitors. Often, that’s all that’s needed tosee why one player is doing better or worsethan their opponent. Their first servepercentage has dropped from 75% down to65% or their return of serve has dropped from77% to 60% - or whatever. In other words, they

can’t maintain their edge; i.e. play according totheir game plan. Casinos don’t have thisproblem because their edge is in-built intotheir games such as the zero on a roulettewheel. Unfortunately for traders, performing attheir best and executing their edgeconsistently is as tough for them as it is fortennis players. And, just like tennis pros, whenyou don’t trade well, guess what happens?Your confidence takes a hit too. Just to beclear, ‘trading well’ does not mean having lotsof profitable trades, it means trading the wayyour trading plan dictates that you should. It’sentirely possible to trade well and have losingtrades, just as it’s possible to trade badly andhave winning ones.

Let’s just delve a little deeper into what atrading plan is and the role it will play inhelping you to trade in a disciplined fashion. Atrading plan is a complete set of rules thatcovers every aspect of your trading life. Manyamateur traders do not have any sort of planto trade by, and enter the markets with scantregard to their risk and profit objectives.Suffice to say, comprehensive risk and moneymanagement strategies lie at the heart of allgood trading plans. Traders with a plan havethe ability to monitor their performance. Theycan evaluate their progress continually,day-by-day, in a way that is objective andcomprehensive. This enables them to tradewithout emotion and with minimal stress. Thetrader without a plan is not able to do this andtheir trading tends to rely upon gut feeling,hunches and tips etc. Trading for them is a nailbiting, emotional roller coaster ride of stressthat, inevitably, results in financial loss.

Obviously, a plan does not guarantee success;that would be too simple. However, if youtrade with discipline and adhere to your plan, itwill help to minimise losses and enable you tostay in the game a lot longer than traders whodo not have a plan. In his book ‘trading online’,

Alpesh B. Patel writes, “While a plan cannotpredict the future, it can lay down how you reactto the possible outcomes. This is why a plan isessential. It is a list of strategic responses toevents beyond your control. You control the onlything you can control – yourself”.

Think of your trading plan as a roadmap. It isquite literally the route that will take you fromwhere you are now to where you want to bewhich, for most traders, is consistentprofitability. In this analogy, consistentprofitability is the destination. To embark on acar journey from, say, John O’groat’s to Land’sEnd without a good roadmap or SatNav would,probably, be unwise and the possibleconsequences of doing so are obvious.Similarly, to embark on trading without a clearidea of where you are going, and how you aregoing to get there will, almost certainly, resultin increased stress, sleepless nights andfinancial loss - or all three. The question youmust ask yourself is this: if you wouldn’t dreamof driving from the north of Scotland to themost southerly tip of England without adetailed roadmap or SatNav, why on earthhave you not got a detailed and clearly laid outtrading plan?

A trading plan will make the act of tradingsimpler than it would be if you traded withoutone. It will limit your opportunity to make badtrades and it will prevent many psychologicalissues from taking root. It will help you toachieve these things because wherever you areon your trading journey, it will not only act as aroadmap, but also locate your position as well.Most importantly, if your trading is going badly,you will know it is down to one of only threepossibilities: either the characteristics of themarkets have changed, or something in theplan is not working or you are not adhering tothe plan. If the plan is a good one and it is backtested and paper traded, (or forward testedwith a very small amount of money), then the

fault is likely to be your poor discipline insticking to the plan. But, what if you are losingmoney whilst trading without a plan? It isvirtually impossible to distinguish what you aredoing right from what you are doing wrong.You have no way to evaluate your results,therefore the likelihood of being able todiagnose the fault and correct it is small andcould take forever. A trading plan is yourpersonal GPS device to locate your positionand, if you have made a wrong turn, it providesthe means to identify where you went wrongand how to get back on track. You are able toevaluate continually your results and, moreimportantly - your discipline - in a manner thatis objective and comprehensive. It is anotherexample of being process-driven and isextremely difficult to do if you do not have aplan.

A trading plan should take away much of thedecision making in the heat of the moment.Emotional issues will become very powerfulwhen real money is on the line and, as likely asnot, force you into making irrational decisions.This is what markets do. They mess with youremotions. This is because they are predicatedon two of the strongest and most basic humanemotions of all: fear and greed. How to dealwith these demons is what we’ll cover next.

EmotionsWhen you have knowledge, skill andexperience; a thoroughly tested trading planwhich you execute with discipline andconfidence; your trading ought to be calm andstress free. However, this will take time andexperience to achieve and, in the early days,there could be times when your stomach isknotted with fear or your head is spinning with$ signs. We are human beings after all; we areemotional creatures. Emotions and themarkets are a very mixed bag. Emotions inothers are, potentially, a source of opportunityfor you as a trader. By the same token, your

emotions could be a source of opportunity forthe people on the other side of your tradesand the cause of your undoing.

Lots of traders and investors lost money in thedot com crash in the spring of 2000.Companies that had next to no income – letalone profits – had ridiculously high valuations.The higher they got, the more people piled intothem, motivated by fear and greed. Fearbecause they were worried they’d miss theboat when everyone around them was makingeasy money, and greed because they wantedsome of that easy money for themselves. Thenthere were those who could see what wasgoing on. They didn’t buy into the hype and thesky high valuations; they knew it wasunsustainable and so they went short themarkets instead. Even though they werecorrect, many of this group lost money as well.In the famous words of John Maynard Keynes,‘The markets can remain irrational for longerthan you can remain solvent’. How galling itmust have been to be forced out of one’s shortpositions for a loss as the markets continuedto rise, only to then witness a crash whichwould have made huge profits. This littlelesson in recent history teaches us valuablethings about the markets:1. Taking trades based on strong emotions israrely a good idea.2. Trade what you can see is happening, notwhat you think might happen, as you can losemoney even when you’re ‘right’.3. Good timing is often essential – especially todirectional traders.Given the topic of this sticky, we’ll confine ourattention to the first of these three lessons toexamine why taking trades based on emotionsis liable to result in financial loss. In his T2Warticle entitled: Lessons from BehaviouralFinance Lee Bohl writes: “It should come as nosurprise that people feel pleasure when they winand pain when they lose but what might surpriseyou is that the psychological impact of wins and

losses of the same magnitude is not the same.According to research conducted by Nobellaureate Daniel Kahneman and Amos Tverskypeople feel the sting of a loss two and a half timesmore strongly than the pleasure of a gain of thesame size. This phenomenon, often called “lossaversion”, is at the root of one of the mostcommon of all trading mistakes- holding on tolosers for too long.”

As a new trader, you’ll continually feel thepleasure associated with winning and the painassociated with loss. In time, the highs andlows should start to even out because you’llknow that any one trade is not important. Itdoesn’t matter whether or not your last tradewas a winner or a loser and, just asimportantly, it doesn’t matter if your next tradeis a winner or a loser either. What matters isthat you trade consistently well and thatcollectively, over time, your results produce apositive expectancy. ‘Trading well’ meanstrading with confidence, trading with disciplineand, most importantly, trading in accordancewith your trading plan.

Remember the tennis stars mentioned earlier?You often see them punching their fist in theair after a winning shot or looking up to theheavens in dismay after a losing one. However,the respective pleasure and pain they feel isvery short lived and they quickly put it behindthem to focus on the next point. They knowthat they’ll have lots of winners and losersthroughout a match, so there’s little pointexpending too much emotional energy on anyone of them. (Okay, the one exception is thepoint that wins or loses them the match!) Theyalso know that their opponent could win moregames than them, but that they can still winthe match. And so it is with traders. Yourwin:loss ratio can be less than 50%, but youcan still be net profitable because you winmore on winning trades than you lose onlosing ones.

So, what’s the bottom line with emotions?Basically, you have to monitor them andcategorise them, knowing that some emotionsare not conducive to trading well. Some of thetraders who were stopped out of their shortpositions in the days and weeks leading up tothe crash in March 2000 will have been a bitmiffed – to put it mildly. Some of them mayhave tried to recoup their losses and shortedthe market for a second time as it plummeted.They may or may not have got lucky. Eitherway, they weren’t trading well – as per thedefinition provided above. They were allowingtheir emotions of anger, fear and greed todictate what, when and how they traded. In themonths before the crash, there were loads oftraders who had made some serious coin asthe markets soared ever higher. It was easy.But they weren’t trading well either. They weremotivated by greed, their (over)confidence wasnot based on knowledge or acquired skill andtheir trading plan – such as it was – comprisedof going long only on tech stocks. True, manyhad experience, but it was only based on a bullmarket which, naively, many thought wouldjust keep on keeping on.

Clearly, trading that’s based on emotions ispotentially harmful to your financial health. Asthe examples above illustrate, some emotionscan be categorised as being ‘bad’ for traders.Does this mean all emotions are bad? In hisarticle entitled Emotions, Decisions andDiscipline Steve Ward puts forward the case ofthat some emotions are not only positive, butare essential in order to trade well. So the keythen, is to know what you’re feeling at anygiven time and to think about how youremotions affect the way you trade. If you tradein the evenings when you get home from workand you’ve had a stressful day – give themarkets a miss that night. If you’ve had a stringof very profitable trades and you think you’vegot the Midas touch – be extra cautious. It’s

about self-awareness and being sensible. Onlyallow emotions that have a positive impact onyour trading to influence when, where andhow you trade.

SummaryIf you play roulette in a casino, the house edgeis the white zero slot on the wheel. Wheelswith a single zero provide the casino with apositive expectancy of just 2.70%. That’s small,but it’s enough to make fortunes for theirowners and ensure that the pews at GamblersAnonymous are always full. When you developyour trading methodology, you must identifywhat you think is your edge. When you papertrade it, it should result in a positiveexpectancy. If it doesn’t, you don’t have anedge. If it does, your next challenge is totransfer it to the live market trading realmoney. That’s the point at which the ideasdiscussed in this sticky will really come intotheir own. The light bulb will flick on. You’ll ‘getit’. Well, hopefully you will anyway!

You can have a brilliant methodology, basedon exhaustive research with a brilliant tradingplan to match. However, if you can’t trade itconsistently well, then your P&L will yoyo upand down quite erratically. And if that happens– stop trading immediately and investigatewhy. Assuming you forward tested the planand the results were consistent, then there’sunlikely to be anything wrong with the planitself. That leaves two other possibleexplanations: either market dynamics havechanged or you’re not following your plan. Inmost cases, the latter is more probable thanthe former.

Trading well is all down to you and is dictatedby your confidence, attitude and how you feelabout yourself and the markets. You’ll gainconfidence by becoming a student of themarkets, and by being process-driven in youracquisition of skills and experience. Discipline

is about knowing what to do and when,regardless of what the markets throw at you. Agood trading plan will include everyconceivable scenario with your response inblack and white. If you ever find yourself in aquandary, unsure of what to do next, thenyour trading plan isn’t robust enough and isinsufficiently well thought through.

Lastly, some emotions may be beneficial toyour trading but there are definitely some badones that have the potential to ruin youfinancially. You are who you are and how yourespond to certain circumstances or events willbe different to the next person. Therefore,there is no general ‘one size fits all’ prescriptionabout what to do or not do in any givensituation. You have to work that one out foryourself. But hey, the good news is that theperson on the other side of your trade is in thesame boat, but s/he probably hasn’t read thissticky (or anything similar) and, even if theyhave, they probably won’t act upon it. Unlikeyou of course. Hint, hint!

Last edited by timsk; Dec 14, 2012 at 3:15pm.Reason: Updating

Dec 14, 2012, 1:56pm #3

T2W Bot

808 PostsJoined Dec 2004

Other Resources on T2W & Beyond

Listed below are some great resources thatyou’ll find in the Psychology forum, elsewhereon T2W and beyond . . .

T2W THREADSPsychology... the poll by shadowninjaIn this thread members discuss their beliefsabout psychological issues and whether or notit affects their trading and, if it does, in whatway.The Perils of Prediction by barjon

This thread discusses the trader’s need to beright and the role of one’s ego in attempting topredict market direction.

T2W ARTICLESPsychology (Traderpedia)This article appears in the old Traderpediasection of T2W and makes particular referenceto the work of Mark Douglas, a very highlyregarded author of several books on traderpsychology.Psychology (Articles)The second psychology link is to the sectionwithin the library of T2W Articles devoted totrading psychology. Check them out! Articlesworthy of special mention are any by Brett N.Steenbarger who is a very well respectedtrader, author, coach and psychologist. Listedbelow are a couple of other articles that havegenerated some interesting discussions frommembers. The titles speak for themselves.Why Don’t we Keep Stops by Vadym GraiferTrading Psychology from a 9 Year Old by LanceBeggs

Trading Plan Template by Tim WilcoxIf you’re unclear about what a trading plan is orhow to go about creating one, this articleshould be of help.

EXTERNAL LINKSTraderFeedThis is Brett N. Steenbarger’s blog that containsa wealth of information and insight. A mustread!The Importance Of Trading Psychology AndDisciplineA useful Investopedia article with lots of linksfor additional research.

Found a good thread, Article or website thatyou think other members would like? Post alink to this Sticky - or PM it to timsk - and we'lladd it here.

Last edited by timsk; Dec 14, 2012 at 2:32pm.

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