Introduction
You may find yourself asking: „Why is there a Psychology section in my trading course?“ The answer is simple: The markets are largely based on Psychology. Emotions move the world and so do they move the stock market. The good thing: If we can manage to „ignore“ what our own emotions are telling us we have an edge over everyone who doesn’t. What exactly this looks like we will dive into now. Again we will remind you to actually study what you are about to read:
What do humans act on?
Humans base their decision making usually on Emotions and afterwards rationalize their behavior with logic.
Since we are interested in the financial markets, and how they work, we will only look at fear and greed.
Fear: In response to fear humans often try to avoid or escape perceived threats. These behaviors may include increased alertness, rapid heartbeat, avoidance of dangerous situations, and seeking reassurance or protection from others. (LeDoux, 1998; Öhman & Mineka, 2001).
This is a very elemental concept in the market. Many traders, if a stock drastically and swiftly decreases in price, think with fear in mind. They panic sell. They try to escape the perceived threat of loosing all their money by exiting the markets.
If we would be out in nature and we are confronted with a lion, dropping everything and escaping that fearful situation is most likely life saving. However, in a market situation panic selling usually doesn’t result in a good outcome. This behavior also compromises any strategy which has hopefully been thought out before. No strategy should include „I will sell when it dumps and I’m panicking“
The second elemental concept is greed:
Greed: When experiencing greed, humans often exhibit behaviors characterized by an insatiable desire for more wealth, resources, or power. These behaviors may include hoarding and a relentless pursuit of material gain…(Sivanathan & Pettit, 2010; Zhang et al., 2019)
Many traders, if a stock drastically increases in price, will be confronted with greed and fear of missing out. Often people in those scenarios will see the potential upside of the market and think they can make an amazing return. This often goes hand in hand with irrational decision making such as: using capital that people cant afford to loose, using a leverage which is to high and simply entering the market at an irrational time and price. Many people totally ignore the always possible downside and simply think about what they could gain. They do not take profit as they expect prices will go much higher. They enter the market after the big move has happened because they think it will go up again.
One mental trap many fall into: Once you mentally calculate how much more money you could make if you did x unrational increase in leverage if the market would go to x unreasonable price target you have already lost.
How does this give us an edge?
Firstly, quite simple, if we actually know these things and have truly learnt them, we do not fall into the same traps. Being able to recognize that you are acting based on emotion rather than logic can take some time but if you keep this in mind on every single trade and any time you review a past trade you will learn rather quickly. How exactly this can be done we will look into in the next chapter!
After mastering the first step and successfully avoiding that we ourselves fall into the trap we go over to step two: Judging market sentiment.
Most individual traders aren’t capable of controlling their emotions as they mostly aren’t even aware that they are the reason they enter or exit their trades. These emotions are also well reflected in what people say. Judging market sentiment on places like Twitter allows us to gauge what most people are thinking.
Again an example of the crypto market: The initial rally of the Bitcoin bull cycle from 35.000$ to 72.000$ displayed the sentiment perfectly on Twitter. Many people were showing off the profit they had made, people were asking their community what new car they should be getting and everyone thought the future would be bright and nothing could happen. But something did happen. We saw a correction which completely flipped the sentiment. Suddenly everyone wasn’t talking about their price targets but rather about how deep they think the price can go. No more profit was shown, everyone was too scared to enter the market and a slight panic set in.
The following chart also shows at what stage of a cycle usually which emotion is at play. You can even study this on yourself. If you suddenly realize you are under the impression that markets can only go up and it’ll go so much higher the market may actually have peaked!
An exercise you can do right now is look at certain charts which are at different parts of their cycle and see what you intuitively think. Do you think its going lower? Do you not believe it’ll go up again soon? Do you think it will go up so much higher?
The chart we just mentioned shows us a typical cycle going from a low point to a peak and then back to a recession which results in a higher baseline than before the rally
We will now explain each part of the cycle in detail and how you could potentially act:
Uncertainty: This is a part of the cycle where investors aren’t sure whether the price of the asset will increase or not. They aren’t ready to invest at all or will only do so with a small amount of their portfolio. People are driven by the fear that the market will not reach past hights again or make new ones. Experienced traders: If they have concluded that the asset has potential to increase in price they enter here as this is the best entry point.
Optimism: This occurs once there has been a sign that the asset actually increases in price. This is not the best part to enter as some of the move has already happened but it is not near the peak yet either. People start to have more trust in the market and trough fear of missing out buy into it. This is already where greed comes in for many. Experienced traders: They may take some partial profits of their position they bought at a lower price point and buy into the asset during dips.
Euphoria: This is the most thrilling part of the cycle. These emotions are hard to fully bring across if you have never experienced them yourselves but no matter how rational you are these emotions usually get to you. That is why studying and practice is so ultimately important. Here traders have fully abandoned any rational thinking and have shifted to the mindset „prices can only go up“. Full on greed is on display at this point. Experienced traders: They know what comes next. They sell their positions and do not buy out of fear of missing out.
Overconfidence: This is the last part of the cycle which is driven by greed. Investors are still fully in the euphoric state of their „up only“ mindset and miss to consider important metrics which would tell a rational mind that the market may have already peaked. Experienced traders: Based on their strategy they decide what to do. They make a rational decision. Afterall, they have probably already concluded a top was in.
Panic: This fear driven part of the cycle is when everyones emotional base gets completely turned around and people suddenly see that the market may not be as healthy as they thought. Panic sets in as people try to get rid of their assets before they become worth even less. Experienced traders: They understand that panic isn’t beneficial for a trader. Since they have already exited their positions mostly they aren’t heavily affected anyways. If they are they wait to sell at a rational price even if their body is telling them to sell and avoid the danger immediately.
What do we learn from this:
-markets move based on Psychology
-understanding our own emotions gives us an edge over others who don’t
-markets move in cycles based on these emotions
-sufficiently understanding the market sentiment helps in making a judgment where in the cycle we are and what the best move may be
Also: Markets will psychologically test participants and usually only reward the ones who are most resilient and best positioned
Now that you have learnt how relevant these emotions are in a market let us look into how you can control your own.
Controlling emotions
It does not matter how much time you have been trading for and how knowledgeable you are you will still have to deal with your own emotions. Some people say it is as easy as making a plan where you define buy and selling points but even sticking to that plan while controlling fear and greed can be very hard.
In our opinion controlling emotions is the single hardest thing while trading. Technical analysis isn’t learnt in a single day but getting the hang of it is quite easy in the grand scheme of things. Controlling your emotions is so challenging for some that they would have to invest so much resources into doing so they cannot even become traders. But don’t worry. We will help you to overcome these challenges.
Putting a negative spell on yourself by saying „you are not made for this“ may not be the right way. Anyone can potentially learn it, it may just be harder for some individuals than others.
So: how do you control your emotions?
Unfortunately we cannot tell you what you may want to hear: that there is a super simple way of doing it really fast. It takes time. It takes mistakes and repeating the process over and over again.
You can either learn the hard way or the harder way. Usually humans, even if they know something isn’t smart, they tend to only act upon that knowledge once they have felt the pain of ignoring it. If you can read about not giving in to your emotions while trading and successfully implement it first time, great! You are the absolute 1%! For most reading the knowledge isn’t enough. Again: That is exactly why we implore you to actually study what we give you.
Now, how do you minimize the damage that may happen and accelerate the pace of learning?
Minimizing the damage is the easier part here. Simply use proper risk management (as outlined the our trading strategy section). As a quick guideline: Do not ever enter trades with 100% of your portfolio. Only trade with money you are willing to loose. Only use 2-5% of your portfolio on a single trade. This will make sure that you will not blow your entire account even if you make a colossal mistake.
Now the harder part: How to accelerate learning?
be exposed to the market - if you only look at a chart and think what you may have done you will never get the needed lesson and pain from trading which you need. You will also never actually experience the emotion to the fullest, thus not truly learning how to control it.
Journal every single trade. Every entry, every exit, every PnL, position size and how long you held the position for. This allows you to analyze what you did in retrospect and visualize if you are profitable or not. It also gives you the chance of reflecting if you bought into the asset for a rational reason or because emotions took over.
Analyse your journal and always be mindful of your emotions. Even while trading: pay attention to what your mind is telling you. The below listed signals are just a few examples but beware: Your mind is trying to trick you. Your emotions are telling you that you should escape the situation or take more advantage of it. As we have learnt this is far from rational.
Signals:
„If price goes here (any number that is way beyond your initial target) I will make x% profit“
„If this happens I can buy this“
„If I increase my leverage and my setup works I will …“
„Oh no, i missed the move and its going up. I better enter now!“
„Oh no, price is going down. Its probably going to zero! Sell!!“
„Prices have been increasing so well. This market cannot fail!“
If you are thinking any of these or other similar thoughts and act upon them you are on track for making irrational decisions. These thoughts usually happen while you are trading. Be aware! They are coming. How can you protect yourself from them? Make a strategy. Define risk management. Define entry and exit for your trade. If you are curious how a strategy should look and what to look out for when making one, check out our Trading Strategy section!
How exactly you can practice we will look at in the next chapter!
At the end of the day trading is just maths combined with being able to create a strategy that works more than 50% of the time. If you can do both of those and strictly do what your plan says you will most likely be profitable. Again: Simply sticking to the plan is way easier said than done. It is ok not to be a good trader when you start. But being a beginner doesn’t mean you have to do stupid things. Risk is a big part of why people usually loose money on trading rather than make any. If you risk 1% of your portfolio, which should be money you are ready to loose anyway, you can make 100 bad trades before your account is gone. Many beginners loose huge chunks within a few trades. Do not compromise your strategy because you get impatient and want money quick. Most people who make money quick will loose that money even faster. Why? Because they don’t actually have the skills to make that money. They just lucky. And luck isn’t something you can rely on.
What can we learn from this?
-be exposed to the market
-journal
-analyze your journal
-analyze your own thoughts and emotions while trading
-make a strategy before you enter trades
-be patient. The hard work will eventually pay off.
-properly manage your risk
You have already completed 2/3 of the course! Congratulations! We hope you are learning and actually understanding what we are trying to convey! Now, the last part of the course is Study. Here we will tell you why most people aren’t profitable and give a more in depth look on how you can practice.
You have completed 2/3 of the course!