The Importance of Trading Psychology and Discipline
As a trader at any skill level, you know how important it is to do your homework and understand the status, fundamentals, and inner workings of a company that you are investing in. It’s also important to recognize the direction of the market’s trends. However, it is actually even more important to maintain a high level of discipline over your emotions.
As a trader, you know that you are often required to make quick decisions because you are rapidly moving in and out of stocks. This is where the psychology and discipline of trading is important because you need to be in a certain state of mind to remain on top of your investment endeavors.
A big part of this discipline is to control your emotions and fully adhere to your trading plan and understand when to book profits and losses.
Understanding Your Fears
When you are involved in trading and stocks are down, it’s understandable that you will be a little scared. Unfortunately, this fear might cause you to overreact and liquidate your holdings, go to cash, and refrain from taking any more risks of losing money. This action might prevent you from some losses, but you also risk missing out on potential gains.
One way to help deal with fear is to understand what the fear is. By definition, fear is a natural reaction to what is perceived as a threat. In trading, that fear could be a reaction to a posed threat to your profit or potential to make money. You will be able to combat fear if you consider what exactly you are afraid of and why.
If you ponder the issues of your fear at a time when you are not emotionally charged, you are better able to determine how you might react in a given situation. For example, if you think things out ahead of time, you might be able to identify your feelings of fear during a trading session. By acknowledging your fears, you can focus your efforts on moving past the emotions that might distract you from completing a successful trade. This exercise takes practice, but it is necessary to preserve the health of your portfolio.
Greed is Your Worst Enemy
A common statement cited on Wall Street is pigs get slaughtered. When investors are winning, many of them hang on to their winning positions for much longer than they should in the hopes of getting every possible tick. This is risky and can result in a devastating blow to your profitability. Despite being aware of the greed factor in trading, it is a difficult emotion to overcome. Many traders have an inherent desire to keep doing better so they push the boundaries of their trades. It is important that you recognize this emotional trait and develop your trade plan on rational decisions, not emotions.
The Importance of Following Trading Rules
To avoid the risk of emotions undermining your trading efforts, it’s a good idea to establish guidelines based on your risk-to-reward relationship before you enter a trade. These trading rules can function as a safety net that can prevent you from a catastrophic loss. For example, if a particular stock is trading at $15 per share, you might consider getting out at just below $15 to put in a stop loss order and exit the trade. Your rules might not apply to only price targets. You might consider certain macroeconomic reports or specific positive or negative earnings as a guideline that will affect your trading decisions.
For example, a signal to get out of a trade might be if a large buyer or seller enters the market. Another guideline might be a limit on the amount you win or lose in a day. For example, if you win a certain profit amount, according to your rule, you would be done for the day. In contrast, if you lose a certain amount, it might be a signal for you to get out and go home for the day. Sometimes it’s more reasonable to just take what you can get and quit trading for the day even if the market has the potential for additional gains.
Periodically assessing your performance helps you correct past mistakes and prevent similar mistakes in the future. It also helps keep your mind clear, in the proper zone, and psychologically prepared to trade.
Below is a helpful visualization by Foxytrades.com of the 7 main emotional mistakes that tend to damage aspiring trader’s results. In addition to the pitfalls, the graph also shows solutions for each problem.