Trading Psychology Potholes
Trading presents a lot of psychological challenges. We easily fall into thinking traps and can be run rough-shod by our emotions. Developing awareness of the common trading psychology potholes helps every trader not only negotiate these challenges, but become better traders. Here are five trading psychology potholes and some guidance on how to deal with them.
- Chart patterns that represent themselves as good trades. We see a bull flag and immediately think, “Easy trade, go long.” Shortly after taking the trade, it’s under water. We didn’t stop to assess the market background. If we did, we would have seen that this “bull flag” was signaling distribution at monthly resistance. Our mind jumped to an unwarranted conclusion.
- What happened yesterday is going to happen again today. This is known as the Recency Effect. Traders may have a few losses in a row and then avoid taking the next trade believing the prior losses influence the results of the current trade. Yesterday’s trade does not determine today’s trade.
- I’m great and I’m on a roll! We tend to attribute good things to ourselves and anything bad that happens to outside factors. Winning trades are due to personal skills and getting stopped out is the market’s fault. When we have a few winning trades in a row, we can feel invincible, let our guard down, and naturally become sloppy.
- Aversion to trading losses. This is a big one. It’s a natural response that becomes amplified from trading while inexperienced. It causes us to do all kinds of account-draining actions such as holding a loser beyond the stop point to avoid taking the loss. It also has us seeking unrealistically high win rate trade setups. Losses are a normal part of trading. Make room for them.
- The “Disposition Effect.” We have a strong tendency to become conservative with gains and become risky with losses. It’s related to loss aversion, but goes further. Winning trades are cautiously cut short to bank profit and dodge imagined loss. Losing trades are treated in a converse manner. We hang onto them hoping they’ll return to profitability. We might even add to the position to lower the breakeven point. Greater risk is taken in handling a losing trade; playing it safe occurs with a winning trade. We should be doing just the opposite.
Trading Psychology Pothole Guidance
- Become aware of the potholes and your tendency to hit them. A trading journal is a good place to reflect on your tendencies. Raising your awareness is crucial in overcoming them.
- Pause and Think. Don’t jump into a trade or hold a losing position without first thinking it through. Is this really a good trade (check background conditions)? Is it smart to cancel my stop?
- When you’ve had good success, be wary. Now is the time you are most vulnerable to making poor trading decisions. Make sure your trades meet all your criteria.
- Know your trade’s probability profile. If you know the trade has a 70%-win rate, then that last loss was just one of the 30%. It doesn’t affect the current trade.
- Accept losses. They are an inevitable part of the game. Plus, they can teach you about yourself, your trade, and the market. Embrace them.
- Cut losers short, let winners run. Strive for this. It is the kind of behavior all great traders display.