Trading Psychology: The Mental Game Beyond

DO YOU EVER FEEL THAT EVERY TIME YOU EXPECT THE PRICE OF AN STOCK TO MOVE ON AN SPECIFIC TRAJECTORY, WHAT HAPPENS IS THE EXACT OPPOSITE?

This brings us to our topic of today; Trading Psychology.

Trading psychology refers to those emotions and cognitive processes that determine the success and failure of any trade. Trading psychology consists of biases and other mental errors an individual is inclined to make and how to overcome such tendencies.

There are two main emotions related to trading: Fear and Greed. Fear makes us avoid risk for probable gain and earn tiny profits, while greed leads to getting into the trade with a never-ending desire to earn large profits. As susceptible individuals, we require a mental framework to gain money out of the market and need to develop an edge over others through fundamental and technical analysis. Fundamental analysis, in general terms, means searching for the true value of a stock, especially undervalued ones. Technical analysis is the study of trends and patterns in behavior over a period.

Here we will talk about what it might take to be a consistently winning trader. 

     "The consistency you seek is in your mind, not in the markets."

                                         -MARK DOUGLAS

In his famous book, “Trading in The Zone" by MARK DOUGLAS, we learned it is not about how you perfectly predict the market, but how well you understand yourself while trading. Mark Douglas brought most of the attention towards trading psychology and many researches and findings have been going on in this subject till date.

Speaking about what we might need to have for consistent winning trades, they are:

1. A Method: Finding a method that works for you is the real deal. A combination of fundamental and technical analysis or having an edge over a specific indicator will help rather than a concoction of multiple indicators. In the context of trading, the number of times you are right in your trade is called the HIT RATE and the payoff from any trade is the RISK TO REWARD ratio. The money you make is a function of both HIT RATE and RISK TO REWARD.

2. Manage your money: While many focus on a high HIT RATE, traders lose more when they are wrong than what they make when they are right. That's why considering risk and reward is equally vital. 

For Instance,

     Hit rate =90%

     Total trade= 10

     Getting right on trade makes 10, and getting wrong loses 90.

      Payoff = (9*10)-(1*90) = 0

This is what happens when you don't follow a proper risk and return framework. You need to set out guidelines based on your risk-reward tolerance for when to enter a trade and when to exit it and also set a profit target and put a stop loss in place to take the emotion out of the process.

Managing our unwanted fear and greed is what defines our capability to manage money in trading.

3. Manage ourselves: People are often susceptible to being euphoric and make bad choices after 3-4 consecutive winning trades. Individuals tend to make big bets and get broke. Managing ourselves might be the trickiest of all, as everything depends on our ability to handle ourselves.

Every individual is prone to be affected by cognitive biases and emotional biases like negativity bias, loss aversion bias, gambler's fallacy, confirmation bias, hindsight bias, and self-serving bias, among others.

To overcome such biases and inconsistencies in trade returns, one has to build a discipline and follow it over the trading period. Again, the major challenge is to follow such a plan without deviation for over 20-30 trades because as human beings we are incapable of detaching ourselves from any biases and there is no neural pathway to avoid such biases. Individuals with better strategy and probability of success also fail sometimes in trading games because they don't adhere to any one system until a neural pathway is built.

Therefore, to build a neural pathway that's capable of resisting such biases in the decision-making process, we can start preparing a journal where we can build the whole system of taking trading decisions without any attachments and following only those predetermined principles. Having self-discipline, self-awareness, and the practice of emotional detachment is equally necessary. 

In conclusion, biases are an inevitable part of human thought and perception, and we can only mitigate the extent to which they impact our results as traders. Through proper discipline and awareness, it can be achieved, but we won't ever be free. JUST BUILD A SYSTEM AND STICK TO IT THROUGH THICK AND THIN.

Contributed by Suman Dhakal. 

Suman Dhakal is currently in the 8th semester pursuing his BBA at Prithvi Narayan Campus, Pokhara and has a keen interest in Behavioral Finance. You can reach Dhakal on LinkedIn.