Trading Psychology, Discipline, and the Importance of Overall Balance

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Contents

The Importance of Trading Psychology

Containing fear and greed are key to making money

Many skills are required for trading successfully in the financial markets. They include the abilities to evaluate a company’s fundamentals and to determine the direction of a stock’s trend. But neither of these technical skills is as important as the trader’s mindset.

Containing emotion, thinking quickly, and exercising discipline are components of what we might call trading psychology.

There are two main emotions to understand and keep under control: fear and greed.

Snap Decisions

Traders often have to think fast and make quick decisions, darting in and out of stocks on short notice. To accomplish this, they need a certain presence of mind. They also need the discipline to stick with their own trading plans and know when to book profits and losses. Emotions simply can’t get in the way.

Key Takeaways

  • Overall investor sentiment frequently drives market performance in directions that are at odds with the fundamentals.
  • The successful investor controls fear and greed, the two human emotions that drive that sentiment.
  • Understanding this can give you the discipline and objectivity needed to take advantage of others’ emotions.

Understanding Fear

When traders get bad news about a certain stock or about the economy in general, they naturally get scared. They may overreact and feel compelled to liquidate their holdings and sit on the cash, refraining from taking any more risks. If they do, they may avoid certain losses but may also miss out on some gains.

Traders need to understand what fear is: a natural reaction to a perceived threat. In this case, it’s a threat to their profit potential.

Quantifying the fear might help. Traders should consider just what they are afraid of, and why they are afraid of it. But that thinking should occur before the bad news, not in the middle of it.

Fear and greed are the two visceral emotions to keep in control.

By thinking it through ahead of time, traders will know how they perceive events instinctively and react to them, and can move past the emotional response. Of course, this is not easy, but it’s necessary to the health of an investor’s portfolio, not to mention the investor.

Overcoming Greed

There’s an old saying on Wall Street that “pigs get slaughtered.” This refers to the habit greedy investors have of hanging on to a winning position too long to get every last tick upward in price. Sooner or later, the trend reverses and the greedy get caught.

Greed is not easy to overcome. It’s often based on the instinct to do better, to get just a little more. A trader should learn to recognize this instinct and develop a trading plan based on rational thinking, not whims or instincts.

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Setting Rules

A trader needs to create rules and follow them when the psychological crunch comes. Set out guidelines based on your risk-reward tolerance for when to enter a trade and when to exit it. Set a profit target and put a stop loss in place to take emotion out of the process.

In addition, you might decide which specific events, such as a positive or negative earnings release, should trigger a decision to buy or sell a stock.

It’s wise to set limits on the maximum amount you are willing to win or lose in a day. If you hit the profit target, take the money and run. If your losses hit a predetermined number, fold up your tent and go home.

Either way, you’ll live to trade another day.

Conducting Research and Review

Traders need to become experts in the stocks and industries that interest them. Keep on top of the news, educate yourself and, iif possible, go to trading seminars and attend conferences.

Devote as much time as possible to the research process. That means studying charts, speaking with management, reading trade journals, and doing other background work such as macroeconomic analysis or industry analysis.

Knowledge can also help overcome fear.

Stay Flexible

It’s important for traders to remain flexible and consider experimenting from time to time. For example, you might consider using options to mitigate risk. One of the best ways a trader can learn is by experimenting (within reason). The experience may also help reduce emotional influences.

Finally, traders should periodically assess their own performances. In addition to reviewing their returns and individual positions, traders should reflect on how they prepared for a trading session, how up to date they are on the markets, and how they’re progressing in terms of ongoing education. This periodic assessment can help a trader correct mistakes, change bad habits, and enhance overall returns.

Trading Psychology – The importance of the right mindset, discipline and winning attitude while trading

Control your emotions like anger, fear and greed to become a successful trader

In this article we’re going to talk about trading psychology. Trading psychology is about the big emotions, the big mental battles that every trader goes through. These emotions often are the reason why many traders who are starting off will grab the first bit of profit they see and refuse to take a loss. Traders with that behavior often will experience failure, rather sooner than later. The internal battles with yourself in order to become a profitable trader are going to be a lot more important for your trading career than what’s actually happening on the screen.

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The fundamentals of discipline are going to shine through as you battle with each of these emotions. Your control over your emotions is going to reflect itself eventually in your P&L and your consistency. So it’s very important to get an understanding about what these emotions look like, what they feel like. Become aware of trading psychology. Try to find solutions to your emotions as early as possible in your learning process to become a successful trader.

Trading psychology: How emotions can affect trading results

As a trader you’ll experience different emotions in many ways. For example beginner traders often are afraid of getting involved in the market. They’re looking for the perfect entry and as a result they’re too cautious. We’re going to start by looking at the S&P and just talk through a couple of examples of the big emotions. Let’s say you were watching the market in late 2020, after about a two-year consolidation from 2020. The market starts breaking out, has a bit of a sell-off and looking back in hindsight you can tell that it was a pretty hard move up.

Image Source: Tradingview.com

Let’s say that you’re just trying to get involved at some point. You wait for the market to pull back a little bit. You wait for a better support line to get involved. Every time when you miss the entry, you hope for the market to come off over a few days for a sell-off. But you keep missing the entry. You’re getting angry that most of the year’s gone and you are missing entry after entry. Your fear is starting to turn into greed and FOMO (fear of missing out).

Now you’re active on Twitter, you’re active on Facebook, you’re active on Reddit, you’re watching CNBC, you’re talking with your friends who are trading themselves. You’re seeing the big numbers that they’re putting up, you’re seeing how much activity, how much growth they’re seeing in their trading accounts. You feel that you’re losing out on this. You’re not getting part of it. Even though you’re not losing money, the fact that you’re not making money like they are is giving you this kind of anxiety, fear and frustration.

The point where you start losing control

This is the point where you’re asking yourself why you’re not getting involved, why you’re not getting a piece of this pie. Then there is this massive pop up in January 2020. This is the point where your fear finally turns into greed. It turns into chasing an entry. So now all of a sudden you’re just paying up. You’re just paying the ask to get involved. You’re breaking out of your initial trading plan, you’re starting to lose control at this point.

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Whenever you were not getting involved, you were definitely not losing any money. But once you start getting greedy, chasing your entry, just slapping the ask to get in, that’s when you start losing control. Typically once you start losing control of a trade, this is where anger sets in. Especially if you were chasing the entry up as the S&P rallies to all-time highs just after Christmas. You finally get your fill after a small pullback and you’re absolutely slammed over the coming days and weeks. You’re slamming the market, you’re hitting your mouse as hard as you can.

Ignorance, disbelief and irrational thinking

You’re in disbelief that the price has turned against you, just as you finally get your fill. So if you were starting to lose control of the trade and break your plan as you were chasing the entry, this is where you fully lose control of the trade. You’re not aware of your trading psychology and you disregard any trading plan or strategy you ever had.

You’re not puking, you’re refusing to sell. This is where you’re going to take that hit and hold on because you know if it ran this much in the last few months, it can do the same again. You’re just not thinking straight, you’re totally irrational and that’s when your account is going to get wiped. You’ve forgotten your trading plan, you’ve disregarded it. You allowed the emotions to control you, instead that you are controlling them.

Realistically at this point, if you can manage to get some capital together to get involved again in the future, you’re going to be too afraid to get involved based on this experience. You find yourself back in this situation, looking for the perfect entry, missing it all the way. It’s a vicious circle of revenge trading that you’re opening yourself up to. Refusing to get a handle on these three big emotions (fear, greed and anger) is setting you up for a career of frustration and ultimately failure in the trading game. We’re now going through some solutions to these emotional trading issues.

How to control your emotions and become a better trader

You may be asking yourself how to better control your emotions. First, you have to acknowledge that your emotions are there. They’re always going to be there. However, you can control and move past them, accept that they’re going to be part of the trading career that you’re looking for. You can utilize your emotions, understand and control them. This will filter through into your consistency, which will filter through into your trading profits at the end of the day.

As we move through the solutions to each of these emotions, you’ll notice that the primary base to each one is having the right trading plan in place. This is something that we’ve already covered in our article about planning your trade and trading your plan. As an active trader you’ll notice rather sooner than later that whenever you deviate from your trading plan, whenever you forget about it, that’s when your trade starts breaking down. That’s the point when your emotions start taking control of you. Ultimately, the primary step to control your various emotions is having a better trading plan at the beginning and the determination to stick to it. We’ll now go through the three big emotions:

Let’s start off with fear. This is the emotion where you’re too afraid to get involved. You’re too cautious and you find that you’re missing all your entries. The stock is running away from you. You’re just not getting involved. What you might want to start doing is just taking a step back from the particular stocks that are on your watchlist. The stocks that you’re trying to get involved with. Instead, go for something that’s a little bit calmer. Something that has a lower average daily range and that you’re not going to be too afraid to hold overnight or over a week.

You want to start getting used to the feeling what it’s like to be in a position for more than a day. What it’s like to be in a position for more than two weeks, for a month, for six months. You’re going to start building that trading experience rather than chasing immediate results. It’s especially important for your trading psychology if you’re just starting off and if you find that you are getting that kind of fear and caution that is detrimental to your initial entries.

Tiptoeing into a trade to build trading experience

So find a stock that’s moving a little slower. Just try and dip the toe in. Go to the absolute minimal size, be it one share, two shares or whatever it is that makes sense for you. Just get involved, start holding it overnight, assuming that it’s going to stick to its average daily range and not going to be too offside one way or another, unless there is breaking news. That’s something you obviously should always be in touch with and be aware of.

Now once you’re involved in the market, it’s very easy to take off some size. For example, buy two shares and take one off after a day. Likewise, buy 100 shares and take 50 off the next day or whatever makes sense with your own capital amount. But you need to start getting involved if you want to be a trader. You need to start building that trading experience. Find a slower kind of stock, go in with the minimal size and be willing to take half off straightaway as you build that experience. This can help you gain more confidence when getting involved in the financial markets.

Greed

The next emotion we’re going to deal with is greed. While Gordon Gekko in the movie Wall Street is telling us that greed is good, it can also heavily impact your trading results, in a negative way. But how do you recognize greed as a trader? How do you get over this part of your trading psychology? How do you avoid greed hurting your trading strategy, your portfolio and your overall account size? It’s pretty simple! If fear is where you force yourself to get involved by tiptoeing into the market, greed is really forcing yourself to stay out by acknowledging that it’s there.

A perfect example is that 2020 run that we saw earlier in SPX, in the S&P. If you’ve been missing your entries and you’re watching this huge run in January 2020 happen, this is where you’re going to be super frustrated. You’re going to be super angry. You’re just going to be slapping the ask to get involved. This is where you’re going to be breaking your trading plan, assuming that your plan has a perfect entry point.

When your trading plan is starting to break up, you’re losing control and you’re chasing the entry. The minute you find yourself stepping out of the paradigm, out of the perimeter that you created, that’s when you got to realize that it’s happening. Take a step back, exit your positions, certainly start reducing size and get your emotions under control.

The fear of missing out (FOMO)

Greed often results from a fear of missing out (FOMO), from seeing what other people are doing. Your friends are making money in their brokerage accounts, you’re seeing all these results posted on Twitter, Facebook or Reddit and CNBC is just running special after special on this amazing bull market.

It’s very important that you don’t care about what other people are doing and the success they are having. The biggest and most successful trader I ever knew did not talk to anybody on the trading floor during market hours. He was a day trader, he cared about nothing but his own plan, his own trading and his own trading results. He didn’t want to know what you’re involved in, what you thought of that break out in the S&P or whatever. The only thing he was following was his own day trading plan and he was absolutely killing it.

Anger

If you haven’t been able to control your fear. If you’ve chased entries as a result given in to your greed, your fear of missing out. The next emotion you’re probably going to experience is anger and frustration. How is this happening? Why is it happening to me? What are top traders doing differently? This isn’t fair, I don’t deserve this!

We’ll stick again with the previous example in the S&P. So you’ve missed all this move, you’re chasing it, you’re jumping in and then you’re hit with the big sell-off. You’re thinking the market was just waiting for you to get involved. This is where you start slamming the mouse or start hitting your screen. I’ve actually seen it happen, people start hitting their desks. It’s not good to see and it’s not good for anybody, including the person themselves or yourself if it’s you who’s experienced this kind of anger as a trader.

The market has turned against you, just after you were getting involved. This is where you finally start giving up your trading plan completely. If you are breaking the plan just to get involved, going for entries above your optimal price, this is where you’re likely just start to absolutely disregard any puke points you had. You’re completely losing control of your trading. Whatever kind of risk control you had, for example that you won’t lose more than 1% of your account value per trade, that’s out the window straight away, particularly on huge red days that happen in the blink of an eye.

The importance of rational thinking

If you’re missing your puke point and all of a sudden the market closes much lower, this is where you start thinking irrationally like: “Oh, there’s no way it’ll open lower. It should bounce back tomorrow, I’ll just hold for one more day”. The next day there is a massive sell-off and you’ll be thinking again: “Oh, there’s no way it’ll go down a third day in a row, let me just wait for a green day and I’m out of the woods”.

You’ve completely lost control over your trade the minute you’ve missed your puke point. This is where you’ve abdicated a responsibility for your trading plan. Your account is likely to get absolutely wiped in this kind of scenario. So again, this is all happening because you’ve broken your trading plan. You didn’t get out when you said you would. You’ve lost control over your trading psychology and as a result you’re thinking irrationally.

Your brokerage account balance is just going down and you don’t know how to turn it around. The best thing to do here is just to get flat. Exit everything, shut your computer down and get away from the screen. You’ve done damage already, you’re not thinking right. You need to step away and get out of the market. It doesn’t matter if the market bounces back tomorrow, you’re not going to get involved at this point because you’re not thinking straight. You’re on tilt and you’re starting to come off the edge completely.

What to do when you’re on tilt and lose control

As a trader you’ll go through some of the mentioned emotions, particularly anger. Be prepared that you definitely will experience this at some stage in your trading career. It can happen just as a sell-off comes out of the blue or if you’re on a very bad losing run where you’re just having consistent red days. When absolutely everything you’re touching turns to dirt, the same emotions are going to be creeping up. The same anger is going to happen, you’re clicking the mouse aggressively, punching the screen or whatever else you usually do in that situation.

When that happens you just got to get away from the screens. Don’t even check closing prices, get flat, take a break or a short holiday and realize that trading is not the be-all and the end-all. There’s more to life outside of trading full time. It’s always worthwhile taking some time to do self-analysis. Get your trading performance from the last couple of weeks or the last couple of months and try to identify when your trading started going downhill. What are the reasons behind your trading losses? Did you start breaking rules? Maybe the product itself has changed?

Self-analysis can help you get back to profitable trading

Whatever surprising findings you might get from self-analysis, once you start getting back involved in the market, it’s so important to take the very similar steps that we talked about when controlling fear. Go minimal size, stay away from volatile products and be not afraid to take half position off straightaway. You’re looking for baby steps back in. Consistency is going to be the name of the game. Habits are going to drive discipline, discipline is going to drive a better mental space and a better mental space is going to drive better trading results.

You can set small daily P&L targets or a monthly profit target if you’re on a longer-term timeframe. You should put in rigid rules. For example if you have three losing trades in a row or if you miss your puke point, you’ll take a break. Active trading rules like that can really help you lock down the discipline and get back to consistency. Once you start hitting those daily targets, don’t be afraid to step away from the screens.

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You’ll have more confidence and a stronger trading psychology as you got to know that you’re profitable for the last seven days or whatever it is. You got to build the consistency and get your confidence back up. After that you can start increasing size and getting back involved in the market with a strict trading plan and risk management. Trade journals can help you stay on track while working on your trading success.

Conclusion: Learn dealing with emotions as a trader

Having emotions is human, this is no different for professional traders. Ultimately, having the right process to control your emotions is going to be more beneficial than getting the right results, particularly when you’re starting off. This is where you’re going to lock down your discipline, lock down your consistency and your own self belief. The right trading psychology and discipline will help you handle bad runs and put in the bedrock of the foundation for your future trading career. What are your thoughts on trading psychology? Please let us know in the comments below.

Delve inside your mind

How does psychology impact trading? Discover the factors that can influence financial decisions – personality, emotions and moods, biases and social pressures – and hear from experts and traders about the challenges psychology can create.

Click on a factor to explore.

Personality

Personality is the combination of characteristics that make up each trader’s distinct identity. The features of a trader’s personality will predispose them to certain financial behaviours, determine how they will perform and their susceptibility to other psychological influences. Take a look at five key areas of personality: discipline, decisiveness, patience, rationality and confidence.

Social pressures

Social pressures are external factors that can have a direct influence on a trader’s psychology, encouraging them to change their attitudes, values and behaviours. The social pressure to perform in a certain way can cause errors and lead to traders taking on greater amounts of risk. Discover the impact of herding, rumours, news and competition on trader’s behaviour.

Behavioural biases

Behavioural biases are subconscious but systematic ways of thinking that can occur when the brain makes a mental shortcut. Biases can impact the way traders make and implement decisions. Discover six biases that can influence traders: availability bias, anchoring bias, hindsight bias, confirmation bias, loss aversion bias and gambler’s fallacy.

Emotions and moods

Emotions are chemical changes in the nervous system that cause an instant reaction to an event, while moods are a by-product of our emotions that can last for a lot longer. The emotional state of a trader can have a significant influence over the way they react to certain circumstances and triggers. Explore the psychology of fear, greed, hope, frustration and boredom, and the impact they can have on a trader’s performance.

Rationality

What is ‘rationality’ in trading?

Rationality in trading is the ability to make choices that will result in the best possible outcome given the information available. Rational decisions aim to maximise an advantage, while minimising any losses.

Although rationality is all about seeking the optimal outcome, studies have been quick to point out that this doesn’t always mean making money – a rational decision can involve minimising losses and even accepting a loss.1

How can traders become rational?

A common way to improve rational decision-making is through a demo account, which enables you to practise trading and test your strategy without risking any capital.

A demo account can help you to familiarise yourself with market dynamics so that when you start to trade using your own money, you won’t be overwhelmed by feelings of fear – enabling you to trade in a more rational way.

Things to keep in mind.

Fear can cause traders to close positions too early and miss out on profit.

Gambler’s Fallacy

Gamblers’ fallacy can lead to traders basing their decisions on irrational beliefs.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Decisiveness

What does ‘decisiveness’ mean in trading?

Decisiveness in trading is the ability to identify opportunities and act efficiently – this includes making decisions about when to enter and exit trades, assimilating new information into a plan and learning from mistakes.

According IG’s survey, 27% of investors ‘go with their gut’ when making decisions about money. However, research by Gollwitzer showed that ill-informed decisions can lead to excessive risk, because they cause a disparity between a plan and its execution1. Although it is important to act quickly, it is also important to make sure you have taken all the available information into account to give yourself the best chance of making rational decisions.

How can traders become decisive?

The best way to become decisive is to create a suitable trading strategy that outlines what you will need to see in your technical and fundamental analysis before you open a trade. This enables you to identify suitable entry and exit points before you start trading and ensures that your decisions have a solid foundation in historical data and trends, rather than ‘gut feeling’.

If you focus on technical analysis, you’ll use indicators to study signals and trends. The data they give off is then used to establish entry and exit points, and where to place stops and limits. Popular technical analysis tools include Fibonacci retracements, moving averages and Bollinger bands. If you choose to use fundamental analysis you’ll evaluate macroeconomic data, company financial reports and the news to establish how and when to trade.

If you aren’t confident in your ability to stick to your pre-made decisions, you could consider automating your trading strategy. This is where you would set the parameters of your order and allow an algorithm to analyse the market and respond to opportunities as they arise.

Things to keep in mind.

Fear can cause traders to close positions too early and miss out on profit.

Availability Bias

Availability bias can cause traders to act on information that is more accessible than reliable.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Confidence

What is confidence in trading?

Confidence in trading is trust in one’s own abilities and knowledge. Every trader requires a certain level of confidence so that they can identify and act on opportunities, as well as bounce back after a losing streak.

IG’s survey found that investors and traders had higher levels of confidence when it comes to financial decision-making than non-investors. However, there is a difference between confidence and over-confidence, which is an unrealistic view of one’s abilities. Research by Dorn and Huberman found that, of the 1345 German investors they surveyed, those who considered themselves more knowledgeable than average were actually more prone to excessively buy and sell assets1. This habit can lead to further losses and decisions that are based on fear rather than research.

All traders will experience losses, but a confident trader will know that everyone has bad days and that sets them apart is learning how to minimise these losses.

How can traders become confident?

The best way to become a confident trader is by trading using a demo account, which enables you to test your trading strategy in a risk-free environment using virtual funds. Alternatively, you could opt to backtest your trading strategy by taking a chunk of real data from a selection of markets and running your strategy against it.

Both methods enable you to build up confidence in how your strategy would perform, without using any actual capital. However, it’s important to remember that neither provides a perfect reflection of a live market, as they won’t always take factors such as liquidity into account when executing your trades.

To avoid being overconfident, just remember that there is never an end to how much you can learn and the experience you can develop. Even the most successful traders can learn more and develop their strategy further.

Things to keep in mind.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

Rumours

Rumours often cause individuals to trade based on unreliable information.

Loss Aversion Bias

Loss aversion bias can cause traders to let losses run, potentially eroding profits.

Patience

What is ‘patience’ in trading?

Patience is the ability of a trader to wait for signals that indicate that it is time to enter or exit the market. This could include making decisions that delay instant gratification in the hope of a future benefit.

IG’s survey found that 66% of participants trade or invest as they recognise it will provide a better return than cash savings. But if a trader doesn’t have the discipline to stick to their trading plan and the patience to wait for the correct market conditions, it can have a huge impact on their long-term goals.

A study by Freeman-Shor found that only 21% of the stock investments analysed realised a return of over 100%, even though many of the shares went up by significantly more over time1. This was because very few individuals had the patience to wait for the trend to run, preferring to sell for a much smaller profit than risk losing what they had made.

Although it is unreasonable for traders to expect huge returns from every trade, it is important not to ‘snatch profits’ in small amounts out of fear or loss aversion . Although this might give a sense of instant gratification, there is the risk of losing out on a much larger gain.

How can traders become patient?

To develop patience, it is important to understand that your desired market movement might not happen straight away or at all. Building a suitable risk management strategy is a great way of managing impatience – this should include setting stop-losses and limit orders.

For example, a trailing stop-loss will automatically follow your position by a certain amount of points. This enables you to lock in your profit if the market moves in your favour, but it will remain in place if the market falls – closing out your position if the market moves against you.

Things to keep in mind.

The Art of Execution: How the World’s Best Investors Get It Wrong and Still Make Millions, Lee Freeman-Shor (2020)

Greed

Greed can lead to irrational decisions in the pursuit of excessive gains.

Gambler’s Fallacy

Gamblers’ fallacy can lead to traders basing their decisions on irrational beliefs.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Discipline

What does ‘discipline’ mean in trading?

Discipline in trading is the practice of sticking to strategies, avoiding holding onto losing trades and taking profit at the right time. It is an attribute that regulates attention, emotional responses and decision making .

Without discipline, traders risk letting their emotions cloud their judgement, which could lead to large losses. In fact, a study by Lock and Mann found that the median holding time for losses is over four times as long as the holding time for gains1, and this lack of discipline makes a trader less likely to be successful in the future.

How can traders become disciplined?

The best way to become disciplined is by creating a trading plan and outlining a risk-to-reward ratio – this compares the amount of money you are risking to the potential gain to your position. In theory, with the right ratio, you could lose more than you win, and still make a profit. For example, if your ratio was 1:3, you would only need to be successful on three out of ten trades to have an overall profit.

According to IG’s survey, only 55% of investors believe that they are disciplined and will stick to the rules they have outlined for themselves. By sticking to your trading plan and risk management measures, you can reduce the likelihood of being caught out by large losses.

Things to keep in mind.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

Anchoring bias

Anchoring bias can lead traders to rely on an initial piece of information.

Patience

Patience is vital to finding the best trading conditions.

Gambler’s fallacy

How can ‘gambler’s fallacy’ affect traders?

Gambler’s fallacy in trading is the tendency of an individual to think that a trade will go a certain way based on past events – even though there is no substantive evidence to support the trader’s thinking. The term originated from the inclination of gamblers to think that a bet might go a certain way based on previous results.

When applied to trading, a study by Rakesh found that 55% of investors who took part believed that a random event would occur again just because it had occurred in the past1. This could cause a trader to base a decision on previous analysis, even when the indicators which had worked for them in the past are no longer relevant or helpful given the current market movements.

How can traders prevent gambler’s fallacy?

You can minimise the risk of gambler’s fallacy affecting your trading by basing your decisions on up-to-date analysis and setting a clear risk-to-reward ratio – which compares the potential loss to the potential gain for each trade you open. This can help you to think clearly and assess each situation on its own merits, and will also minimise the effects of any losses on the overall value of your trading account.

An example of a risk-to-reward ratio would be if you placed a guaranteed stop on a trade, capping your maximum loss at £100, along with a limit giving you the potential to realise a £300 profit. In this scenario, the risk-to-reward ratio would be 1:3.

With a 1:3 ratio, you could generate a profit by only being right 30% of the time. This is because if you placed ten trades risking a maximum of £100 each, you would lose £700 from your seven losses, but you would make £900 from your three gains. Of course, if you’re taking on less risk for a greater potential reward, it’s likely the market will have to move further in your favour to reach your maximum profit, than it will to hit your maximum loss.

Things to keep in mind.

Confirmation Bias

Confirmation bias causes traders to disregard information that doesn’t match their beliefs.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

Loss aversion bias

How does ‘loss aversion bias’ affect traders?

Loss aversion bias is a preference for avoiding losses over acquiring the equivalent gains. It implies that the fear of a loss is greater than the pleasure of a gain.

Research by Odean looked at 10,000 trading accounts held between 1987 to 1993, and found that individuals have a tendency to hold on to losing positions for a much longer period of time than winning trades, out of a fear of realising a loss.1

Percentage of trades closed at a gain and loss

IG data backs this up, showing that although traders close over 50% of trades at a gain, they lose significantly more on their losing trades than they make on their winning ones. This emphasises that instead of accepting a small loss, many traders will hold on to their positions and risk eroding their profits.2

How can traders prevent loss aversion bias?

A key step in preventing loss aversion bias is acknowledging that it exists. When you start to create a trading plan, it is important to consider how much you are willing to lose as well as how much you want to gain. And once you have established your trading plan, it is important that you have the discipline to stick to it to avoid taking unnecessary losses.

One way of doing this is by setting a suitable risk-to-reward ratio, which compares your capital at risk to the amount you stand to gain. For example, if you set a ratio of 1:3, then you’d only need to profit on three out of ten trades to have an overall profit. The correct risk-to-reward ratio could ensure that your gains are always at least as large as any potential losses, giving you the confidence to overcome loss aversion bias.

Things to keep in mind.

Discipline

Being undisciplined can cause traders to hold on to losses.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Gambler’s Fallacy

Gamblers’ fallacy can lead to traders basing their decisions on irrational beliefs.

Confirmation bias

How can ‘confirmation bias’ affect traders?

Confirmation bias is the tendency for traders to search for, and put greater weight behind, information that confirms their pre-existing beliefs or predictions. This could mean that a trader disregards negative news about an asset because they believe that the good outweighs the bad – even though this may not be the case.

Confirmation bias is linked to overconfidence, which can lead to poor decision-making and overtrading. A study by Park, Bin Gu, Kumar and Raghunathan found that traders with stronger confirmation bias are likely to exhibit greater levels of overconfidence and trade more frequently. This can lead to them obtaining lower profits because they might lose more often. IG’s survey revealed that 29% of traders and investors go with their gut when making decisions – a sure sign of overconfidence.

How can traders prevent confirmation bias?

Confirmation bias can be prevented by carrying out your own analysis – whether this is technical or fundamental – and trusting that it is correct, even if it clashes with earlier predictions or preconceptions.

Technical and fundamental analysis can be a great way for you to identify whether you should be buying or selling a particular asset – for example, overvalued stocks or undervalued stock. Analysis can confirm the true value of an asset in a more accurate and definitive way when compared to say, preconceived biases or gut feelings.

It could even benefit you to actively seek out information that clashes with your preconceptions because this could counteract your confirmation bias – forcing you to think about each trade in terms of its own merits.

Things to keep in mind.

Confidence

Overconfidence can cause traders to have unrealistic views of their abilities.

Loss Aversion Bias

Loss aversion bias can cause traders to let losses run, potentially eroding profits.

Hindsight Bias

Hindsight bias can make traders falsely confident in their decisions after an outcome is known.

Hindsight bias

How does ‘hindsight bias’ affect traders?

Hindsight bias in trading is the tendency for individuals to express that they ‘knew it all along’, once they know the answer to a question or the outcome of an event that was previously uncertain.

The consequence of hindsight bias is that it often leads to a false sense of confidence . IG’s survey found that up to 55% of traders believe that they are very disciplined when trading – however, this is a dangerous mindset because biases can creep in and lead to irrational trading decisions.

A study by Biais and Weber found that those who exhibited the hindsight bias failed to remember how uncertain they had really been before they made their decisions. This means that they may have been inefficient in making choices regarding risk management. From the 85 investment bankers surveyed, all were found to exhibit hindsight bias.1

How can traders prevent hindsight bias?

One way to minimise the impact of hindsight bias is by keeping a trading diary. A trading diary is used to record your progress, keep track of your trading, and plan and refine your strategies. You should also use it to make a note of how you feel before, during and after each trade. By writing down whether you feel confident, afraid, hopeful or uncertain, you will be better placed to get a sense of when you were successful.

By mapping the reasons behind trading decisions and comparing them to the desired outcomes, you can use your past trades to inform your future strategy. So, instead of trying to make sense of what happened by oversimplifying the reasons for past events, you can learn from the outcome.

Things to keep in mind.

Discipline

Being undisciplined can cause traders to hold on to losses.

Rationality

Rational decision-making is key to minimising losses.

Confidence

Overconfidence can cause traders to have unrealistic views of their abilities.

Anchoring bias

What is anchoring bias in trading?

Anchoring bias is the tendency for traders to allow an initial piece of information to have a disproportionate influence on future decisions, regardless of its relevance.1

For example, research by Kaustia, Alho and Puttonen showed that individual’s estimates of stock returns were significantly influenced by the starting value they were given – the ‘anchor’2. When participants were given a high historical stock return they were more likely to estimate that the future return would also be high, while a group given a lower initial value had far lower estimates.

Anchoring bias can have dangerous consequences in trading, as it might mean that a trader holds on to an asset far longer than they should do, or that they make an inaccurate assessment of an asset’s worth based on the anchor value.

How can traders prevent anchoring bias?

The best way to prevent anchoring bias in trading is by performing comprehensive research and analysis of the market to identify your own anchor.

IG’s study showed that only 28% of traders and investors used personal experience as a source of information. But by doing your own analysis of macroeconomic trends and historical data, you will be better placed to identify key support and resistance levels. It is important to have confidence in your own plan before you look at someone else’s estimates – whether this is an analyst or fellow trader.

Things to keep in mind.

Availability Bias

Availability bias can cause traders to act on information that is more accessible than reliable.

Hope can make it hard for traders to cut their losses and lead to unnecessary risks.

Competition

Competition can cause traders to adopt problematic habits.

Availability bias

How does ‘availability bias’ affect traders?

Availability bias is the tendency to open or close positions based on information that is easily available, rather than sources that are more difficult to find. It can cause traders to act on false or unverified information, which can lead to higher levels of risk and loss.

Traders tend to lean towards what is personally most relevant, recent or emotional, even long after the event is over. The mind can take a shortcut based on examples that come to mind immediately, rather than on research and analysis. For example, if a person has a family member who recently lost money on a bitcoin trade, they may be less inclined to speculate on the cryptocurrency because it is hard for them to imagine that the market can be profitable.

In fact, a study by Moradia, Meshkib and Mostafaei found that there is a strong correlation between judgement and data availability. By surveying investors of stocks listed on the Tehran Stock Exchange, the researchers concluded that decision-making would likely improve as the amount of information released to the public increased.1

How can traders prevent availability bias?

The most common way to prevent availability bias is to conduct extensive research and analysis. Participants of IG’s survey were comfortable using multiple sources to gather information on trading and investing. Although 56% used the internet, some also used newspapers, specialist publications, financial advisers, television and podcasts.

Fundamental analysis is used to examine internal and external factors such as earnings reports, how the sector is performing, and the health of the economy, while technical analysis looks at historic price data and indicators to establish key entry and exit levels for each trade.

If you don’t feel confident enough to trade on live markets, you could test your strategy on a demo account first. This enables you to practise trading with indicators and test your strategy in a risk-free environment using virtual funds.

Things to keep in mind.

Fear can cause traders to close positions too early and miss out on profit.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

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