Essentials Of Trading Psychology

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Essentials Of Trading Psychology

This is a discussion on Essentials Of Trading Psychology within the
Psychology, Risk & Money Management forums, part of the Methods
category; What are Essentials Stickies? Welcome to the Essentials of
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Dec 14, 2012, 1:55pm

T2W Bot

808 Posts
Joined Dec 2004

#1
Essentials Of Trading Psychology
What are Essentials Stickies?
Welcome to the Essentials of Psychology Sticky.
Stickies are threads that are stuck to the top
of a forum index. They contain information
about the forum youre in that is of critical or
ongoing value - hence the Essentials name. If
there is anything missing from this Essentials
Sticky, or if there is content that is incorrect or
misleading, please contact timsk, T2W Content
Manager and, all being well, it will be
amended.
Trading Psychology Whats it all about? Post #2
If youre new to trading, youll doubtless be
jumping from pillar to post trying to absorb as
much as you can about this business, before
deciding if its right for you. Whichever site you
surf, book you read or trader you talk to, there
will be one subject that crops up time and time
again: trader psychology. Whats it all about
and why is it such a big deal?
First of all, lets clarify what is meant by the
term trader psychology. Wikipedia denes
psychology as an academic and applied
discipline that involves the scientic study of
mental functions and behaviours. There are
three mental functions and behaviours that
apply specically to traders: condence,
discipline and emotions.
In the next post well examine each one in
detail and why your ability to deal with them is
vital to your success. If you dont keep them in
check, then you can kiss goodbye to a good
nights sleep, your glorious head of hair
assuming you have one - and those perfectly
manicured ngernails. Oh, another thing

youre likely to kiss goodbye to is your trading

account. Afraid so. If any one of these three
mental functions and behaviors are allowed to
run riot, then a blow up (traders jargon for
losing most or all of their account) is all but
inevitable.
Other Resources on T2W & Beyond - Post #3
There are some great resources regarding
psychology beyond the walls of this forum. In
post #3, you will nd useful links to other areas
of T2W and beyond, with a short prcis about
each one.

Dec 14, 2012, 1:56pm

T2W Bot

808 Posts
Joined Dec 2004

#2
Trading Psychology Whats it all about?
If youve read any other Stickies or FAQs on
T2W, youll have gathered by now that there
are very few absolutes in trading. In other
words, there are very few things about which
most traders let alone all traders - agree. One
such absolute is trader psychology. If your
head is in the wrong place, the chances of you
screwing up increases exponentially.
Ultimately, screwing up tends to result in one
or two things, sometimes both: failing to
realise a prot and/or taking a loss. (Please
note that losing trades are not necessarily
screw ups and, by the same token, its
possible to make a right pigs ear of things and
still exit a trade with a prot.) Then theres the
question of scale. Minor screw ups are to be
expected, especially amongst novices. These
are ne, necessary even, to teach the trader
important lessons about themselves and about
the markets. Major screw ups are best
avoided, not least because few traders can
aord to have very many of them. The goal of
this Sticky is to equip you with the basic
information required to ensure that all your
future screw ups are minor learning

experiences, not major disasters from which

you may never recover. To achieve that, lets
start with the rst of the three mental
functions and behaviours mentioned in the
opening post: condence.
Condence
As a trader, you are engaging in a performance
activity. In this respect, you are in the same
arena as actors, musicians, athletes and other
sports men and women. Top sports stars have
to have condence in their abilities. Watch any
sport, whether its a team game like football or
an individual game like tennis and you can
usually see whos playing with condence and
who isnt. In the nal stages of the Wimbledon
tennis championships, you will often hear
commentators say things like: S/hes having to
dig deep to nd the winning shots when it really
matters or Its all about who wants it the most.
The point is that, arguably, there isnt much
dierence in terms of sheer ability between
the top 10 players in the world. Yet, Federer,
Dvocovic and Nadal repeatedly divvy out the
major trophies between them. To a greater or
lesser extent, what separates these three
champions from the other seven top ten men
is condence.
As a trader, especially when youre starting out,
youre competing against professionals at the
top of their game - right from day one. There
are no junior markets where you can practice
and gradually work your way up to the senior
circuit. There is no newbie friendly
kindergarten market where your broker will
give you your money back if everything goes
pear shaped. The best you can do is to paper
trade on a demo account and, when you make
the transition to trading real money, start
trading with the smallest size possible. It is
often said that the worst thing that can happen
to a novice trader is that they start on a
winning streak. If you took up tennis and, only
having played the game for a few months,

somehow found yourself in a competitive

match against Federer you would lose. Thats
a no-brainer, obviously. The only way you
could possibly win would be if Federer
sustained an injury and retired. Ironically, the
same thing does not apply to trading. You can
win from the get go and then youre likely to
suer from the one thing thats even worse
than having no condence at all being
over-condent. Make no mistake, the minute
you start to think youve got the markets
sussed and its just one great big personal ATM
machine, youll get your ar$e handed to you on
a plate. And that comes with an ocial T2W
guarantee!
So, what is required then is balance;
condence without being over-condent,
based on knowledge, acquired skills and
experience. Hollywood actors can u their
lines, famous musicians can hit bum notes and
pro footballers can score own goals. However,
whilst all these things can and do happen,
most top performers in these professions are
condent that theyll do well most of the time,
based on their training and dedication to their
craft. And so it is with traders. However, unless
youre taken on by a bank or proprietary
trading rm, getting to the stage at which you
can justiably be condent in your own
abilities is likely to take longer than you think.
Much longer. To be able to consistently take
prots out of the markets over the medium to
long term as a retail trader, is akin to taking up
acting 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 to
becoming session musician. Or taking up
football with the aim of playing for a team as a
salaried player. Some people will say that
trading really isnt as dicult as any of the
above. Maybe theyre right. However, one thing
is for sure. Most novice traders start o by
being over condent, fuelled by hope and
fantasy, without any real idea of the scale of

the challenge that lies ahead of them. Having

read this far, you no longer have that excuse.
Gaining condence is a slow process and will
reect the time and eort you put in to
acquiring the necessary knowledge and honing
your trading skills. To do this eciently, you
will need to structure your learning. Think
about the top musicians and sports men and
women mentioned earlier. To a greater or
lesser extent, the quality of their performance
when theyre under the spotlight is dictated by
the study and practice they put in when theyre
away from it. That study and practice isnt
arbitrary or random; its highly organised. You
must try and manage yourself with the same
sort of mindset that a great manager like Alex
Ferguson uses to manage Manchester United.
Brett Steenbarger refers to this as being
process-driven. To acquire real condence,
based on true ability, youll need to become
process-driven. Heres how he explains it:
Sports teams practice their plays again and
again so that they can execute automatically and
awlessly in games. A surgeon has a researchtested process for conducting a delicate surgery;
an artist has a process for training an apprentice.
When traders are process-focused and processdriven, random needs, impulses, emotions, etc.
are less likely to interfere with trading. Equally
important, the process can ensure that traders
are as consistent as possible in doing what they
do best.
Discipline
Condence in ones abilities is the result of
acquired knowledge and practical application
of skills and experience. It takes time and lots
of hard work to acquire. Even if you have good
reason to be condent in your trading abilities,
on its own, its not sucient to ensure success
in the markets. You need more. You need
discipline. The good news here is that
discipline is easier and faster to acquire.
Indeed, you may already be a disciplined

person and just need a few pointers about

how to apply it to the markets. The bad news is
that many traders fall at this hurdle, as it
proves much harder to master than many of
them imagine.
On paper, trading with discipline is
straightforward. Its simply a case of knowing
what to do at any given time and then doing it.
Or knowing what not to do and not doing it, as
the case may be. To achieve this, you must
have a trading plan that details everything
relating to your trading life. Whatever the
markets throw at you, you never want to be
caught like the proverbial rabbit, frozen,
starring into the headlights. Expect the worst
and plan for it. Your trading plan will detail
exactly what your edge is, how to trade it well
and the positive expectancy that youll enjoy
when you do. (For an explanation of the terms
edge and positive expectancy, please refer to
the FAQ Essentials Of 'First Steps' ) The
challenge then is to trade your plan day after
day, week after week, month after month. That
aint easy. Somehow, amidst the highs and
lows of daily life, you have to trade your plan
consistently and methodically. All the while the
markets, i.e. the people on the other side of
your trades, are doing their utmost to part you
from your money. This is one of the reasons
why some discretionary traders turn to
mechanical trading systems, as computers are
a bit more level headed and consistent in their
approach than their human operators.
Lets return briey to the tennis analogy. The
commentators love their match statistics and,
in the interval between games or at the end of
the set, they look at the key stats of the
competitors. Often, thats all thats needed to
see why one player is doing better or worse
than their opponent. Their rst serve
percentage has dropped from 75% down to
65% or their return of serve has dropped from
77% to 60% - or whatever. In other words, they

cant maintain their edge; i.e. play according to

their game plan. Casinos dont have this
problem because their edge is in-built into
their games such as the zero on a roulette
wheel. Unfortunately for traders, performing at
their best and executing their edge
consistently is as tough for them as it is for
tennis players. And, just like tennis pros, when
you dont trade well, guess what happens?
Your condence takes a hit too. Just to be
clear, trading well does not mean having lots
of protable trades, it means trading the way
your trading plan dictates that you should. Its
entirely possible to trade well and have losing
trades, just as its possible to trade badly and
have winning ones.
Lets just delve a little deeper into what a
trading plan is and the role it will play in
helping you to trade in a disciplined fashion. A
trading plan is a complete set of rules that
covers every aspect of your trading life. Many
amateur traders do not have any sort of plan
to trade by, and enter the markets with scant
regard to their risk and prot objectives.
Suce to say, comprehensive risk and money
management strategies lie at the heart of all
good trading plans. Traders with a plan have
the ability to monitor their performance. They
can evaluate their progress continually,
day-by-day, in a way that is objective and
comprehensive. This enables them to trade
without emotion and with minimal stress. The
trader without a plan is not able to do this and
their trading tends to rely upon gut feeling,
hunches and tips etc. Trading for them is a nail
biting, emotional roller coaster ride of stress
that, inevitably, results in nancial loss.
Obviously, a plan does not guarantee success;
that would be too simple. However, if you
trade with discipline and adhere to your plan, it
will help to minimise losses and enable you to
stay in the game a lot longer than traders who
do not have a plan. In his book trading online,

Alpesh B. Patel writes, While a plan cannot

predict the future, it can lay down how you react
to the possible outcomes. This is why a plan is
essential. It is a list of strategic responses to
events beyond your control. You control the only
thing you can control yourself.
Think of your trading plan as a roadmap. It is
quite literally the route that will take you from
where you are now to where you want to be
which, for most traders, is consistent
protability. In this analogy, consistent
protability is the destination. To embark on a
car journey from, say, John Ogroats to Lands
End without a good roadmap or SatNav would,
probably, be unwise and the possible
consequences of doing so are obvious.
Similarly, to embark on trading without a clear
idea of where you are going, and how you are
going to get there will, almost certainly, result
in increased stress, sleepless nights and
nancial loss - or all three. The question you
must ask yourself is this: if you wouldnt dream
of driving from the north of Scotland to the
most southerly tip of England without a
detailed roadmap or SatNav, why on earth
have you not got a detailed and clearly laid out
trading plan?
A trading plan will make the act of trading
simpler than it would be if you traded without
one. It will limit your opportunity to make bad
trades and it will prevent many psychological
issues from taking root. It will help you to
achieve these things because wherever you are
on your trading journey, it will not only act as a
roadmap, 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 three
possibilities: either the characteristics of the
markets have changed, or something in the
plan is not working or you are not adhering to
the plan. If the plan is a good one and it is back
tested and paper traded, (or forward tested
with a very small amount of money), then the

fault is likely to be your poor discipline in

sticking to the plan. But, what if you are losing
money whilst trading without a plan? It is
virtually impossible to distinguish what you are
doing right from what you are doing wrong.
You have no way to evaluate your results,
therefore the likelihood of being able to
diagnose the fault and correct it is small and
could take forever. A trading plan is your
personal GPS device to locate your position
and, if you have made a wrong turn, it provides
the means to identify where you went wrong
and how to get back on track. You are able to
evaluate continually your results and, more
importantly - your discipline - in a manner that
is objective and comprehensive. It is another
example of being process-driven and is
extremely dicult to do if you do not have a
plan.
A trading plan should take away much of the
decision making in the heat of the moment.
Emotional issues will become very powerful
when real money is on the line and, as likely as
not, force you into making irrational decisions.
This is what markets do. They mess with your
emotions. This is because they are predicated
on two of the strongest and most basic human
emotions of all: fear and greed. How to deal
with these demons is what well cover next.
Emotions
When you have knowledge, skill and
experience; a thoroughly tested trading plan
which you execute with discipline and
condence; your trading ought to be calm and
stress free. However, this will take time and
experience to achieve and, in the early days,
there could be times when your stomach is
knotted with fear or your head is spinning with
$ signs. We are human beings after all; we are
emotional creatures. Emotions and the
markets are a very mixed bag. Emotions in
others are, potentially, a source of opportunity
for you as a trader. By the same token, your

emotions could be a source of opportunity for

the people on the other side of your trades
and the cause of your undoing.
Lots of traders and investors lost money in the
dot com crash in the spring of 2000.
Companies that had next to no income let
alone prots had ridiculously high valuations.
The higher they got, the more people piled into
them, motivated by fear and greed. Fear
because they were worried theyd miss the
boat when everyone around them was making
easy money, and greed because they wanted
some of that easy money for themselves. Then
there were those who could see what was
going on. They didnt buy into the hype and the
sky high valuations; they knew it was
unsustainable and so they went short the
markets instead. Even though they were
correct, many of this group lost money as well.
In the famous words of John Maynard Keynes,
The markets can remain irrational for longer
than you can remain solvent. How galling it
must have been to be forced out of ones short
positions for a loss as the markets continued
to rise, only to then witness a crash which
would have made huge prots. This little
lesson in recent history teaches us valuable
things about the markets:
1. Taking trades based on strong emotions is
rarely a good idea.
2. Trade what you can see is happening, not
what you think might happen, as you can lose
money even when youre right.
3. Good timing is often essential especially to
directional traders.
Given the topic of this sticky, well conne our
attention to the rst of these three lessons to
examine why taking trades based on emotions
is liable to result in nancial loss. In his T2W
article entitled: Lessons from Behavioural
Finance Lee Bohl writes: It should come as no
surprise that people feel pleasure when they win
and pain when they lose but what might surprise
you is that the psychological impact of wins and

losses of the same magnitude is not the same.

According to research conducted by Nobel
laureate Daniel Kahneman and Amos Tversky
people feel the sting of a loss two and a half times
more strongly than the pleasure of a gain of the
same size. This phenomenon, often called loss
aversion, is at the root of one of the most
common of all trading mistakes- holding on to
losers for too long.
As a new trader, youll continually feel the
pleasure associated with winning and the pain
associated with loss. In time, the highs and
lows should start to even out because youll
know that any one trade is not important. It
doesnt matter whether or not your last trade
was a winner or a loser and, just as
importantly, it doesnt matter if your next trade
is a winner or a loser either. What matters is
that you trade consistently well and that
collectively, over time, your results produce a
positive expectancy. Trading well means
trading with condence, trading with discipline
and, most importantly, trading in accordance
with your trading plan.
Remember the tennis stars mentioned earlier?
You often see them punching their st in the
air after a winning shot or looking up to the
heavens in dismay after a losing one. However,
the respective pleasure and pain they feel is
very short lived and they quickly put it behind
them to focus on the next point. They know
that theyll have lots of winners and losers
throughout a match, so theres little point
expending too much emotional energy on any
one of them. (Okay, the one exception is the
point that wins or loses them the match!) They
also know that their opponent could win more
games than them, but that they can still win
the match. And so it is with traders. Your
win:loss ratio can be less than 50%, but you
can still be net protable because you win
more on winning trades than you lose on
losing ones.

So, whats the bottom line with emotions?

Basically, you have to monitor them and
categorise them, knowing that some emotions
are not conducive to trading well. Some of the
traders who were stopped out of their short
positions in the days and weeks leading up to
the crash in March 2000 will have been a bit
mied to put it mildly. Some of them may
have tried to recoup their losses and shorted
the market for a second time as it plummeted.
They may or may not have got lucky. Either
way, they werent trading well as per the
denition provided above. They were allowing
their emotions of anger, fear and greed to
dictate what, when and how they traded. In the
months before the crash, there were loads of
traders who had made some serious coin as
the markets soared ever higher. It was easy.
But they werent trading well either. They were
motivated by greed, their (over)condence was
not based on knowledge or acquired skill and
their trading plan such as it was comprised
of going long only on tech stocks. True, many
had experience, but it was only based on a bull
market which, naively, many thought would
just keep on keeping on.
Clearly, trading thats based on emotions is
potentially harmful to your nancial health. As
the examples above illustrate, some emotions
can be categorised as being bad for traders.
Does this mean all emotions are bad? In his
article entitled Emotions, Decisions and
Discipline Steve Ward puts forward the case of
that some emotions are not only positive, but
are essential in order to trade well. So the key
then, is to know what youre feeling at any
given time and to think about how your
emotions aect the way you trade. If you trade
in the evenings when you get home from work
and youve had a stressful day give the
markets a miss that night. If youve had a string
of very protable trades and you think youve
got the Midas touch be extra cautious. Its

about self-awareness and being sensible. Only

allow emotions that have a positive impact on
your trading to inuence when, where and
how you trade.
Summary
If you play roulette in a casino, the house edge
is the white zero slot on the wheel. Wheels
with a single zero provide the casino with a
positive expectancy of just 2.70%. Thats small,
but its enough to make fortunes for their
owners and ensure that the pews at Gamblers
Anonymous are always full. When you develop
your trading methodology, you must identify
what you think is your edge. When you paper
trade it, it should result in a positive
expectancy. If it doesnt, you dont have an
edge. If it does, your next challenge is to
transfer it to the live market trading real
money. Thats the point at which the ideas
discussed in this sticky will really come into
their own. The light bulb will ick on. Youll get
it. Well, hopefully you will anyway!
You can have a brilliant methodology, based
on exhaustive research with a brilliant trading
plan to match. However, if you cant trade it
consistently well, then your P&L will yoyo up
and down quite erratically. And if that happens
stop trading immediately and investigate
why. Assuming you forward tested the plan
and the results were consistent, then theres
unlikely to be anything wrong with the plan
itself. That leaves two other possible
explanations: either market dynamics have
changed or youre not following your plan. In
most cases, the latter is more probable than
the former.
Trading well is all down to you and is dictated
by your condence, attitude and how you feel
about yourself and the markets. Youll gain
condence by becoming a student of the
markets, and by being process-driven in your
acquisition of skills and experience. Discipline

is about knowing what to do and when,

regardless of what the markets throw at you. A
good trading plan will include every
conceivable scenario with your response in
black and white. If you ever nd yourself in a
quandary, unsure of what to do next, then
your trading plan isnt robust enough and is
insuciently well thought through.
Lastly, some emotions may be benecial to
your trading but there are denitely some bad
ones that have the potential to ruin you
nancially. You are who you are and how you
respond to certain circumstances or events will
be dierent to the next person. Therefore,
there is no general one size ts all prescription
about what to do or not do in any given
situation. You have to work that one out for
yourself. But hey, the good news is that the
person on the other side of your trade is in the
same boat, but s/he probably hasnt read this
sticky (or anything similar) and, even if they
have, they probably wont act upon it. Unlike
you of course. Hint, hint!
Last edited by timsk; Dec 14, 2012 at 3:15pm.
Reason: Updating

Dec 14, 2012, 1:56pm

T2W Bot

#3
Other Resources on T2W & Beyond
Listed below are some great resources that
youll nd in the Psychology forum, elsewhere
on T2W and beyond . . .

808 Posts
Joined Dec 2004

T2W THREADS
Psychology... the poll by shadowninja
In this thread members discuss their beliefs
about psychological issues and whether or not
it aects their trading and, if it does, in what
way.
The Perils of Prediction by barjon

This thread discusses the traders need to be

right and the role of ones ego in attempting to
predict market direction.
T2W ARTICLES
Psychology (Traderpedia)
This article appears in the old Traderpedia
section of T2W and makes particular reference
to the work of Mark Douglas, a very highly
regarded author of several books on trader
psychology.
Psychology (Articles)
The second psychology link is to the section
within the library of T2W Articles devoted to
trading psychology. Check them out! Articles
worthy of special mention are any by Brett N.
Steenbarger who is a very well respected
trader, author, coach and psychologist. Listed
below are a couple of other articles that have
generated some interesting discussions from
members. The titles speak for themselves.
Why Dont we Keep Stops by Vadym Graifer
Trading Psychology from a 9 Year Old by Lance
Beggs
Trading Plan Template by Tim Wilcox
If youre unclear about what a trading plan is or
how to go about creating one, this article
should be of help.
EXTERNAL LINKS
TraderFeed
This is Brett N. Steenbargers blog that contains
a wealth of information and insight. A must
read!
The Importance Of Trading Psychology And
Discipline
A useful Investopedia article with lots of links
for additional research.
Found a good thread, Article or website that
you think other members would like? Post a
link to this Sticky - or PM it to timsk - and we'll
add it here.

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

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