Trading Psychology

After spending enough time learning, you should be able to develop your trading system and have your money management rules set up. The third and most important piece of the puzzle is Trading Psychology. The correct mental approach is a key component of successful trading.

Trading psychology involves:

• Controlling the trader's fear.
• Controlling the trader's greed.
• Maintaining the discipline required to follow your method and stick to your money management rules.

The Human Mind: Conscious vs. Subconscious

Understanding the structure of the human mind is crucial, as it is where discipline originates. Psychologists divide the mind into two parts:

• The Conscious Mind (Analytical Mind): This is the calculator or computer that makes rational decisions. This is the 10% visible above the surface, like an iceberg.
• The Subconscious Mind (Emotional Mind): This makes irrational decisions and stores the majority of our thoughts, feelings, and habits, running our lives on autopilot. This is the 90% hidden below the surface.

Bad trading habits are formed through repetition and become ingrained in the subconscious, making it extremely difficult to execute the rational decisions intended by the conscious mind.

Three Most Common Bad Trader Habits

These habits lead to poor execution and prevent traders from following their chosen systems:

1. Fear and Greed: Ancient instincts that, while once useful for survival, do not work well in the modern, man-made environment of trading.
2. Need to Always Be Right: Caused by conditioning where correctness is rewarded and errors are penalized, making accepting losses a very difficult task.
3. No Trading Plan: A failure to plan, resulting in the repetition of bad habits.

Fear and Greed in Detail

Fear and greed are common factors holding investors back. Fear in trading primarily takes two forms:

• The Fear of Loss: Can cause hesitation to trade or compel traders to hang on to losing trades too long.
• The Fear of Missing Out (FOMO): Compels people to abandon rules and enter the market before the trading system signals entry, often resulting in larger and more frequent losses.

Greed is the motivation for overconfidence. Dreams of making money very fast cloud a trader's mind, causing them to abandon their trading system rules in hopes of greater gains.

Tips for Managing Fear and Greed

• Stop Trading for a Day: Take a break to reset your mental state.
• Learn About the Thing You Fear: Uncertainty is a huge component of fear. Develop an understanding of what you are afraid of (loss, missing out, ridicule).
• Trade Smaller Amounts: Start small and work in steps. Building familiarity with a scary subject makes it more manageable.
• Find a Mentor or Coach: Find someone who is not afraid of the issue you face and spend time with that person.
• Admit It and Talk About It: Sharing your fear or greed out loud can make it seem much less daunting.
• One Day at a Time: Stop looking at the grand scheme. Focus only on each successive step.

Overcoming the Need to Always Be Right

The mind is conditioned to strive to be correct. Being wrong is considered extremely bad. This need creates detrimental trading behaviors:

• A trader holds onto a losing position, hoping the market reverses, reinforcing the idea of being "correct."
• A trader quickly takes profits when a position runs in profit, reinforcing the feeling of making the "correct" decision.

This is why beginners tend to cut their profits early, but allow their losers to run.

Reality Check: Successful trading is not dependent on being accurate; profitable traders are often correct less than half the time. Profitable trading is based on balancing risk and reward—allowing profits to run and closing losers early.

Amateurs care about being right. Professionals care about making money. Adapting to this difference is one of the biggest challenges for traders.

Solution: Redefining Loss

Losing is part of the game. The possibility to lose is always there. You can learn to accept losses by redefining their meaning:

• Do not equate loss with failure.
• Consider losing as positive in the sense that it provides feedback to improve your next trades.
• Consider losses as business expenses (e.g., like a restaurant throwing away unsold food but still remaining profitable).

The Necessity of a Trading Plan

A trading plan is a must for all traders. If you fail to plan, you have already planned to fail.

Without a plan, you are lost, relying on rumors and gut feelings. A trading plan outlines instructions for how to react under different possible scenarios. Through repetition, this process builds the good habits needed until following your plan becomes second nature.

The only rational reason to trade is to make money, not to have fun. Trading without a plan removes responsibility and leaves the outcome to chance.

Components of a Trading Plan

Having a trading plan and being prepared for trades helps to keep emotional responses to a minimum. A trading plan consists of three key elements:

1. Entry Signals: The conditions that must be met in order to enter a new trade.
2. Exit Signals: The reasons for closing a trade (e.g., a target was reached or a stop loss was hit).
3. Money Management: The specific amount of capital to risk on every trade.