There are four psychological states of emotions that can affect decision making when trading. They are greed, fear, hope and regret.
You must always make your decisions on your interpretation of the facts. You interpret what is, not what you want to be.
The market neither knows or cares about your feelings. So they are not relevant facts. If you allow these emotions to overly affect your decisions then your trading will suffer.
But you cannot turn off your feelings, and you should not try. So, what’s a trader to do?
Greed is commonly thought of as an excessive desire for money and wealth. In trading, it is better defined as a desire for a trade to provide an immediate and unrealistic amount of profit.
When greed sets in, all a trader can focus on is how much money they have made and how much more they could make by trading more.
But, no actual profit exists until the trade is made and is closed. Until then, there is only a potential profit.
So greed can often cause traders to enter trades that have a poor chance of success.
Worse still, greed also frequently leads traders to ignore sound risk management practices when entering the trade.
Fear is the most powerful of all human emotions and is probably the emotion that traders struggle with the most.
After all, no one has ever jumped off of a building because of greed but they have because of fear. The effects of fear hold true regardless of whether the threat is real or imagined.
Fear is a survival response. When traders become afraid, they sell positions regardless of the price. Fear leads to panic, and panic leads to poor decision making.
Fear is a good emotion if it means you avoid a low probability setup. However, it will work against you if you don’t enter a quality setup because you have recently had a series of losing trades.
Always remember that every trade is an independent event in terms of its probability of success.
Therefore, just because you may have lost money in a previous trade it does not mean you should be fearful of entering the next trade. That’s why we have trading plans.
Trading systems are intended to take the emotions out of trading. If you’re afraid to enter a quality setup, there’s no point in having a plan and definitely no point in trading.
Truly understanding the power of fear is one of the key pieces to improve your trading.
Hope is a feeling of expectation and an individual’s desire or wish for a desired event to happen.
When combined with greed, hope may be the most dangerous of all human emotions when it comes to trading.
Traders will often enter a new trade in the “hope” of recouping past losses or reaching an unrealistic target for performance.
This type of thinking is dangerous because the group (the market) knows nothing about your hopes and could not care less anyway. Only the trader can decide and care about what is in your best interest.
Rest assured, when your thinking slips into hope mode, the market will punish you by taking your money.
Regret is a feeling of sadness over a loss or a missed opportunity. The negative implications are obvious.
It is only natural for a trader to regret taking on a losing trade or missing a winning trade. But it is meaningless to focus on losing trades or missed opportunities.
If you lose money on a trade, then you should simply evaluate what went wrong and move forward.
Other than the lessons that can be gained from evaluating each trade, there is no point to spending further time regretting the decision to enter the trade.
It is also human nature to feel regret when an opportunity is missed. But there is no shortage of opportunities in the market.
Why waste time thinking about a past opportunity which is, by definition, one you can do nothing about? Concentrate on the future opportunities which are there for you to exploit.
If you miss a winning trade, then you must move on to the next potential trading opportunity.
When traders feel regret they tend to chase trades in the hopes of still being able to make money on the position by entering it, even if the market has moved well away from the trigger price.
The problem with this thinking is that the opportunity existed at the trigger price and may not exist thereafter.
To avoid regret you must trust your system and act on the signals it gives you.
The Market has Feelings Too!
Since each market is made up of individual human beings who tend to act in similar ways, this is the case for the group of traders that comprises the market just as it is for individuals traders.
So we can think of market being driven by emotions similar to individual emotions.
It is also the case in respect of individual trades and longer periods of market trends.
It is only the group’s opinion that matters during a trend, although the individual trader must identify the subtle clues as to when a market is about to shift direction.
Waves of Emotions
An interesting point about emotions is that they do not arise either independently or in a random sequence. Instead, they tend to arise in sequences akin to waves.
The chart below aims to illustrate one such wave, albeit somewhat stylistically.
Fear sets in to create the next wave of opportunity.
Notice however that there is typically a correlation between positive feelings about trading and the market and the level of risk that is involved. The best opportunities arise when they are least perceived.
The clear implication is that you must break the link between how you might feel about a trade and your willingness to put money at risk by trading.
How To Improve Your Trading
You will be involved in the market while trading and so you will never be totally objective – unless you use a robot system to do your trading. If you have read the book you will know what I think of those.
As a human, you cannot eliminate emotions or feelings. So your aim is not to be a sort of emotionless automaton.
Understand that it is normal to experience the four powerful psychological feelings of greed, fear, hope and regret when trading.
Indeed, being aware that these emotions are always present is the first step to being disciplined enough to overcome them.
Overcoming them means ensuring that you follow your trading system and the conclusions of your analysis rather than deviations because of some intuition or feeling that arises from something outside the system.
When you can do this, you will find that the results of your stock trading operations will improve.
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