Trading Psychology: The Missing Link
There is a ton of advice on trading setups out there in the blogosphere. Some of it is good, most of it is bad, but none of it impacts your trading as much as your own trading psychology. The "mental game" is usually the missing link that keeps a trader from trading profitably.
Why is trading psychology so important?
It is because human beings are not wired to trade. Our brains are constructed to perpetuate survival, not make money. That is why so many traders know exactly what to do to make money, but still do the exact opposite. Thousands of years ago, surviving in the state of nature did not require long term thinking, assessing probabilities, managing risk or handling draw downs. Instead, it required immediate action.
Here are 5 tips to fix your mental game and increase your profits.
Tip 1: Embrace Small Losses
Dealing with losses is emotionally the toughest thing a trader must deal with. Losses impact our emotions when we take a big loss, are in the midst of a ten trade drawdown, or get stopped out of a stock that immediately reverses and ends up hitting our planned target. The loss trigger leads to revenge trading, micro-managing, poor decision making and a number of other trading psychology pitfalls.
Fix the loss trigger by embracing small losses. Remember that small losses means you are doing something right. You are sticking to proper risk management. You know that these losses mean nothing if they are sandwiched by some bigger wins.
Tip 2: Think About Your Next 100 Trades
Many traders live or die by their next trade. While we analyze every trade, our overall guiding focus should not be gains and losses in the moment, but over time. Don't worry about that one loss. This leads to recency bias that will reek havoc with your mind. Remember, in the grand scheme of your trading, that one loss is meaningless. Instead, think about, no obsess about, the next 100 trades. This will keep you focused on the process and not short term results. Remember, we are trading probabilities and sometimes you will lose on good trades. A drawdown does not mean you are trading poorly. Do not let good trades with poor short term results impact your trading psychology.
Tip 3: Fight Fear By Reducing Risk
Putting on a trade can be scary. Your hard earned cash is on the line, and you do not want to lose it. Anybody who has traded a paper account with success and made the move to real money knows the impact fear has on your trading. Fear manifests itself in trading by making it difficult to pull the trigger on a trade, exiting before hitting targets, pulling out of trades before the stop is hit and other micro-managing issues. If fear is showing up in your trading, reduce your risk. The smaller the potential loss, the less scared you are of the trade. For example, if you usually risk $200 per trade, lower it to $100 until the fear goes away. Then slowly increase risk in small increments until you get back up to $200 and no longer fear the trade.
Tip 4: Fight Greed By Partial Profit Taking
The opposite of fear is greed. While we love the challenge and strategy of trading, ultimately we are in this game to make money. This makes us greedy. Greed impacts traders in two major ways. The first is by making our targets too aggressive and illogical. For example, let's say you enter a stocks at $90 with a target just under resistance at $100. As the stock hits $100, you think to yourself that you'll hold on longer, it'll hit $110 and you'll double your profits. The sounds great but you set your target at $100 for a reason. Your stock will likely pullback at the resistance level. Thus, pretty soon that $10 profit is $5 or you lose it all. Greed turned a winning trade into a loser. Fix this trading psychology leak by taking partial profits. In the current example, take half off at $100, move your stop up to $95. This keeps you strategically sound while also letting your greed play itself out in a positive way.
Tip 5: Fight Greed By Reducing Position Size
The other way greed manifests itself is when a trader trades too big by increasing position size. The trader thinks if she can make $1000 off 100 shares, by doubling the position she can double the profit. While this is true, she is commiting trading suicide because not only is the trader increasing potential profits, but also potential losses. A small drawdown no longer is insignificant, but leads to losses that are hard to come back from. The way to combat this common emotion is to religiously stick to your risk rules. If you have identified $500 as your max risk, you will never take a position size that increases that risk. This is the only way to protect your account. Remember, winning traders play defense before offense.
Sound trading psychology is essential to becoming a winning trader. Humans are not wired to trade effectively, so we must attack the mental game as hard as we do when learning the markets and trading setups.
Take some time to identify your own trading psychology weaknesses. If mental errors like fear, greed, recency bias or issues with taking losses show up in your trading, implement the trading psychology fixes in this article and watch your results improve dramatically.
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