Trading Emotions: The Psychology of Trading and How Emotions Impact Our Decision-Making

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Whether you define yourself as a trader or investor, it’s easy to let emotions run havoc and get in the way of your decisions. Greed and fear, both normal human emotions, can become exacerbated when your own money is on the line. This is particularly true for swing traders — as we’re trading over the short to medium term and trying to profit from dips and peaks in the market.  And as such, our trading psychology really comes into play.

Download the short printable PDF version summarizing the key points of this lesson….Click Here to Download

If you pride yourself on being a reasoned, successful trader, your automatic reaction might be to puff out your chest and say that you don’t let your emotions affect you. But that’s unlikely to be true — emotions are at the heart of trading, and pretending otherwise would be counterproductive.

Besides, as you’ll soon see, blocking out your emotions entirely is just as bad as letting them control you. In this overview of trading emotions, I’ll cover:

  • What the psychology of trading is
  • Emotions to look out for when trading
  • How to create a trading plan
  • Working with others to get to the root of your problems

What is the psychology of trading?

Confused about how trading emotions and psychology link together?

No matter how much research you’ve done into trends, fundamentals, and technical indicators, you’re ultimately relying on your decision-making abilities and impulses to execute the right trades.

This is referred to as the psychology of trading.

As swing traders, we have to make many a quick decision under significant pressure. Maybe the price of one of your stocks just dropped rapidly, and you’re not sure whether to sell it or hold it under the assumption it can recover its losses.

There are two key emotions that come into play when we make these decisions: greed and fear. To a lesser extent, we also have to think about our urge for “revenge” and the effect of euphoria on our trades.

I’ll examine all four of them in detail to give you a clearer picture of what I’m talking about here.

The dangers of being a greedy trader

Ultimately, all traders are here to make money — even if you plan on donating your earnings to charity! But there’s a difference between wanting to make money and taking excessive risks to make it.

Greedy traders fall on the wrong end of that spectrum.

Have you ever watched an asset price rise, known it was a bubble that would eventually burst, but still been unable to accept it was time to back out? Instead, you’ve kept hanging in, believing you could make maximum profits?

Our greed stops us and clouds our judgment.

Instead, emotionally balanced traders are more rational. They’re happy to accept moderate profits instead of taking unnecessary risks to make excessive profits.

This is what we should be aiming to achieve.

Tackle your fear when trading

No matter how long you’ve been trading, it’s hard to completely overcome the fear of an economic crash or losing all your money. But the impulsive and irrational behavior we adopt when we’re fearful results in some of the most reckless moves a trader can make.

Imagine letting your fear take such a hold over you that you sell all your assets, thinking they were about to plummet in value, only to realize that it was a false alarm. Maybe this has really happened to you before!

The good news is that you don’t need to overcome this fear — it probably wouldn’t be great news for your bank account if you smiled and continued as normal during a market crash — you just need to learn to manage it.

We can achieve this through trading discipline, which we’ll examine later.

Managing euphoria as a trader

Euphoria might not sound like such a bad thing — to a certain extent there’s nothing wrong with feeling happy when we do something right. But there’s a difference between “satisfaction” and “euphoria.”

Euphoria implies a rush of emotions that creates a real high. This can make us overexcited when trading and ultimately lead to poor decisions.

Have you ever been so pleased with yourself for executing a few profitable trades that you convinced yourself you were a trading prodigy, then ended up losing more money than you gained because of your confidence?

Don’t let your positive emotions get the better of you. Instead, take a deep breath and a step back, and don’t trade immediately until you’ve calmed down. Trading plans can also help with this, as we’ll soon see.

Resisting the urge for revenge

The concept of revenge within the context of trading might sound strange at first. Who exactly are you trying to get revenge on anyway, you might be thinking? Other traders who do you wrong?

Actually, I’m talking about the market itself.

This links in with greed — when things don’t go our way during trading, it’s easy to get carried away with trying to make up for what we’ve lost. Effectively, we’re attempting to “get revenge” on the market.

In the world of behavioral economics, it’s known as the sunk cost fallacy: we’ll go to extreme lengths to recoup our losses if we once owned something but then we lose it. Why? We view it as something that is rightfully ours.

The truth is that, once you lose something, it’s already gone. Instead of fixating on “making up for” your losses, move on and focus on the next trade.

Establishing trading discipline

Now you know that you need to look out for fear, greed, revenge, and euphoria when trading. But how exactly can you prevent them from ruining your trades?

You need to build greater discipline and establish concrete trading plans in advance. If you’ve already decided how you’re going to react under certain situations, all you need to do in the moment is follow through on that.

Greed, fear, and euphoria might seem like distinct problems, but they’re all closely connected to how you view risk. By planning out the risks you’re prepared to take in advance, you can stop these emotions from taking over.

I’ll explain how you can make a trading plan later, but first, you need to understand how your brain works.

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Get to know yourself

To a certain extent, we all react in the same way to phenomena like greed and fear. But that doesn’t mean that we’re all the same! It’s essential to learn the ins and outs of your psychology as an individual.

Next time you’re trading, take note of how you react to various triggers. What is your natural impulse when you face a loss? At what point do you begin to become uncomfortable? Are you naturally good at judging when it’s time to sell?

Even better, do this journaling when you’re doing a trading simulation and not when the stakes are real — you can return to real trading once you have your emotions under control.

Although this documentation process can be tedious, it will pay dividends in the long run as you learn what your limits are and when you need to take a step back.

Developing a trading plan

Once you’ve figured out how your trading psychology works and accepted that you have tendencies to be fearful and greedy, you can develop a trading plan that works for you.

To do this, you’ll need to decide when you want to enter and exit trades, think about possible scenarios that could emerge, and research the market you’re trading in.

Decide when to enter and exit trades

Don’t leave your most important decisions down to whatever your gut is telling you in the heat of the moment — decide in advance how you’re going to act.

To make a plan about when you’re going to enter and exit trades, you need to have an idea about your preferences toward risk. Risk-averse traders who become fearful easily should set more conservative limits, whereas risk-neutral or risk-loving traders can give themselves more room here.

You might also want to set profit targets and stop losses for yourself. This means that, when either your profits or your losses reach a set amount, you commit yourself to exiting.

This way, you’ll simply be reacting to cold, hard numbers and not your emotions.

Consider possible future events

Instead of focusing solely on the numbers, you might also want to consider which events could happen, and how you want to react to them.

Whether good or bad, which events justify you selling your stocks?

Do your research

Although mastering your emotions and trading psychology is a separate task to researching the stocks and assets you’re trading, it’s difficult to plan appropriately if you have no idea what could come your way.

The better you understand the industry you’re trading in, the better you’ll be at setting yourself limits and plans that make sense. And the clearer a picture you have of which events could happen and what impact they’d have, the less they’ll take you by surprise — meaning your emotions won’t come into play as much!

Read the latest news, study charts and metrics, chat with other traders — and read blogs like mine, of course.

Trading psychology in different types of trading

Whether you’re a forex trader, a stocks trader, a crypto trader, or anything in between, paying attention to your psychology is vital. Although the way our emotions work when trading doesn’t differ dramatically between different types of trading and strategies, it’s still helpful to examine the precise mechanisms for each one.

Now, let’s look at swing trading, day trading, and trend trading.

Swing trading psychology

Swing trading is when you trade fluctuations that take place, usually over a few days.  But just because you have a few days to make decisions, it doesn’t mean that you can’t think long term.

Instead of focusing on yesterday’s trading mistakes, think about how to put yourself in the best position for the future — otherwise, you’ll fall into the trap of thinking about “revenge.”

Day trading psychology

Day traders might be trading any type of asset, but what differentiates them from other traders is the short horizon they trade over — they make their trades over a single day, meaning they have even less time to make decisions than swing traders.

You’ll normally have to make decisions within a few hours, so it’s tricky to reign your emotions in and be rational. Getting to grips with your psychology is essential.

Trend trading psychology

Trend trading is all about analyzing which direction assets are moving in and capturing gains that way. Although analysis and research form an essential part of making the right decisions and predicting trends correctly, you can’t neglect the importance of figuring out when it’s time to back out.

You might be overly happy you’ve predicted something correctly and want to keep riding the gain — that’s why it’s crucial to have a profit target in place. The reverse is also true.

How to control your emotions while trading

Setting up a comprehensive trading plan and understanding how their emotions impact their tendencies will be enough for some people to become better traders.

Others might prefer to go one step further. Why not join (or start) a support group of like-minded traders trying to understand their trading emotions, like Ed Seykota’s Trading Tribe?

The Trading Tribe centers around the idea that carrying out inner work is essential to becoming a better trader. Because of our ego’s interference in how we make decisions, it’s practically impossible to overcome these issues alone. That’s why joining a group is so powerful.

Let’s take a deep dive into the principles behind the Trading Tribe and how their meetings work.

trading-and-emotionsThe structure of the mind

The Trading tribe uses the “Fred” model to help us understand our minds better. No, we’re not talking about some random guy called Fred — Fred is just what Seykota calls the subconscious part of your mind.

It’s a useful tactic to separate your conscious decision-making process from your emotional impulsiveness.

The Trading Tribe methodology teaches us to take what Fred is telling us and carefully decide what we’re going to do with that information. We should never ignore him or take what he’s telling us at face value.

Fred can often be useful or helpful. That nervous feeling you get when you’re 20 meters above the ground and you look down? It’s Fred trying to protect you. Unfortunately, Fred doesn’t know when you’re wearing a harness, so you need to use your logic to make the call.

The same thing applies when trading. Fred’s protective instincts will kick in when you start to lose a little money in the market — but Fred isn’t so good at realizing the difference between what’s most likely a temporary blip from a more threatening, permanent trend.

But bear in mind that we still need to listen to what Fred tells us. If you try to be an emotionless trader, you’ll miss the useful insights that Fred wants to pass on. This is just as much of a recipe for disaster!

What happens when we ignore him? Rather than him going quiet, Fred will simply increase the intensity of your emotions and make sure you feel what he wants you to feel, one way or another.

In the context of trading, this could mean that you block out your nervousness for as long as possible, but end up selling at an even worse price than you were considering originally — without ever analyzing the situation.

How the Trading Tribe works

The Trading Tribe aims to find a third way between blocking your emotions out completely and doing everything they tell you; it teaches you to hone your ability to receive the messages and see what you can learn from them.

This fosters conscious trading by making you more balanced, less anxious, and better able to identify opportunities.

But the benefits go beyond just trading — this is about encouraging your emotional growth, and will probably lead to improvements all across your life.

To achieve these goals, members of the Trading Tribe strive to find the root causes of the way they act and the core needs behind them.

Did you lack validation as a child, and you’re now desperate to receive validation as a trader? Or maybe you never learned to self-regulate your emotions due to your parents never giving you barriers, and now you can’t stop yourself when you’re trading?

Each member of the Trading Tribe takes turns expressing the feelings they have inside themselves as movement; they act out these emotions.

It requires them to connect with whatever they might be feeling inside. Often, the feelings male Tribe members express are frustration and anger which might come out as shouting and fist punching. Once worked through these feelings can lead to connecting to deeper, less conscious feelings. Such feelings can come up when one loses more money than planned or miss out on profitable trades.

It can be an exhausting process but it continues until the Tribe members expel those feelings and the ‘zero point’, has been reached. Fear, greed and other emotions no longer have the same grip of you.

As this process is honed, members should develop a better understanding of their emotional triggers and be able to handle their trades better.

Download the short printable PDF version summarizing the key points of this lesson….Click Here to Download

Final words

Taking notice of your emotions isn’t just something to do if you’re nervous about trading — it can enhance the performance of all traders, no matter how successful or experienced.

As you can see, learning to control your emotions when trading isn’t exactly something you can achieve overnight. You’ll probably experience a few minor (or major) setbacks along the way, then progressively learn about your own psychology and how to control it.

This article was written by Tim Thomas. He was born in Guildford and now lives near Southampton, UK with my family. He started his career in the financial markets and has traded and invested in stocks, options, forex, futures, crypto and real estate for over 20 years. Tim’s website is dedicated to teaching swing trading strategies for profits, helping traders reach their wealth and financial freedom goals.

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