Trading psychology

Trading psychology has become an increasingly popular topic of discussion and research in recent years. It’s no surprise really if one considers the effect that emotions can have on many of the decisions we make as traders.

But what is trading psychology? Well, it has to do with understanding and managing your emotional reactions in the context of trading and financial decision making.

If you’re a seasoned trader, you’re probably very mindful of the way feelings like fear, stress, greed, anxiety and even arrogance can drive financial decision making.

For someone new to trading, this awareness may not be so readily apparent, leading to potentially unfavourable trading outcomes. Developing the ability to recognise certain behavioural patterns and the way in which they can cloud judgement is key to objective and rational trading decisions.

The study of trading psychology encompasses various subfields, with three prominent areas being behavioural finance, emotional trading, and trading instincts. Let’s explore these in a little more detail.

Behavioural finance

As the name would suggest, behavioural finance explores how human behaviours affect financial choices and trading success.

It seeks to identify what psychological influences and biases drive those behaviours among traders and financial practitioners.

It does this in order to understand financial outcomes across sectors and industries.

Behavioural finance also considers that people are not always rational and may lack the ability to control their actions.

Rather, they are impacted by a variety of psychological factors that can affect their reasoning and capacity to make optimal decisions.

Behavioural finance further suggests that decision making in financial contexts is influenced by both mental and physical health. In essence, one’s mental state varies according to their overall well-being.

Some typical behavioural biases consist of overconfidence, herd behaviour, mental accounting, emotional gap, anchoring, self-attribution, and loss aversion.

Emotional trading

Also known as emotional investing, emotional trading refers to behavioural impulses triggered by volatility in the market, which typically leads to emotionally driven trade execution.

The concept suggests that feelings like greed, excitement, panic, fear or even arrogance are routed in emotional trading, resulting in poor trading outcomes.

This is typically exhibited in behaviours like panic selling, overtrading, over leveraging, confirmation bias, and many others.

Emotional trading lacks objectivity, relying on knee-jerk reactions rather than informed analysis, research, or learning.

Learning how to handle one’s feelings is key to mitigate the risk of substantial losses that emotional trading may result in. It requires a significant level of emotional intelligence, resilience, and discipline to manage trading stressors.

Ways of achieving this are investing time in ongoing trading-related education to become more skilled in making decisions based on data, as well as working on emotional regulation and development.

Trading instincts

Another popular area of trading psychology is to do with trading instincts. This concept refers to the notion of intuition or gut instinct driving financial decision making.

Traders may often rely on these senses to open or close positions, but trusting one’s instincts to achieve successful outcomes usually comes with considerable experience and self-awareness.

A beginner trader may not be able to distinguish legitimate trading instinct from emotional impulses, leading to poor decision making. Key to mitigating potentially negative trading outcomes is to adopt a mindset of self-awareness to make more informed and objective choices. This includes recognising the impact of: