Trading Psychology Explained

Do you ever feel stressed when trading? Anxious, hopeful, or scared?

Of course, you do – those are perfectly natural reactions. And unfortunately, they can’t be avoided. However, all of these emotions make trading more complicated, more difficult, and ultimately cause worse outcomes.

So, if they can’t be avoided, what should you do? You should try to manage them – and to do that, you’ll need to understand them. 💡

The topic of market psychology deals with how we, as traders, react to different occurrences on an emotional level. Our feelings and reactions, in large part, are subconscious – but taking the time to learn about them allows you to consciously counteract them.

Most traders don’t put in the effort to understand how market psychology works – and this is part of the reason why many fail. If you master your emotions, you’ll automatically have a leg up on the competition. That knowledge will help you avoid mistakes like the panic selling that cost so many traders money during the 2020 Covid-19 market crash.

You will inevitably feel afraid, hopeful, greedy, or simply sad at one point or another in your journey as a trader. However, it’s absolutely possible to overcome all of those impulses – so let’s find out how.

Ready? Let’s jump in! 🚀

Why Trading Psychology Matters ❗️

Becoming a successful trader is a long, arduous journey. To get there, you’re going to have to master many skills – reading stock charts, analyzing fundamentals, reading financial statements, and plenty more. But even if you do all of that, you’re still not guaranteed to succeed.

Why is that? Because there is another crucial part of the overall equation that doesn’t get talked about enough – and that is your mindset. People, try as we might, aren’t completely rational beings – and there’s no blueprint that will tell you what you need to do. 

You’re going to be out there on your own, and you’re going to have to bear the weight of your decisions alone – sooner or later, emotions seep in, even for the most cold-blooded traders. 

There’s no way to avoid this – but, if you devote some time to learning and understanding how emotions and irrationality play a role in trading, you’re going to be much better prepared to handle those troubles.

That’s where trading psychology comes in – it’s a topic that deals with all of the emotional highs and lows of trading, and how they impact your successes and failures. By understanding it, one can overcome irrational pitfalls and safeguard themselves from unnecessary, costly knee-jerk mistakes.

At times, you’re going to be afraid, euphoric, overconfident, and dejected. As a trader, whenever you are feeling, you aren’t thinking – and trading is a thinking man’s game. You’ll need a certain state of mind in order to stay cool and stick to your plans.

So, let’s do some thinking. Once you’ve learned about the patterns that should be avoided, you will start recognizing them – and you can begin steeling yourself against the inevitable emotional turbulence.

How Fear Influences Trading Decisions 🙀

Fear is arguably the most unpleasant emotion of them all. We’re all well acquainted with it, and in our information-saturated day and age, fear is an almost ubiquitous emotion.

Fear has a compounding effect – when traders panic and get skittish, their sentiment rapidly spreads far and wide – and this has far-reaching consequences. Even if you yourself can manage to avoid fear, you won’t avoid the effect that it has on the market.

Let’s take a moment to be extremely honest here, though – you won’t avoid fear. And that’s perfectly natural and even reasonable – losing money isn’t just unpleasant, it can have real, tangible consequences for your life.

Fear is simply a defense mechanism – it tells you that there’s danger and that you should be careful. That’s all well and good, but that mechanism has a habit of kicking into overdrive and paralyzing you or becoming so intense that you start making bad calls.

FDR once famously said that we have nothing to fear but fear itself. And that statement applies marvelously to trading – the actual things that we’re afraid of usually pose much less of a danger to us than the crippling sensation of being afraid.

Fear will lead you astray. If you give in to it, you’ll end up selling positions that you should hold, and you’ll pass on sensible opportunities that should be taken. 

Although you shouldn’t let fear dictate your choices, don’t go overboard. Whenever there is fear, you should take a good hard look at the facts to ascertain the real risks that are present – but don’t ever ignore fear. It’s all too easy to hyper-fixate on a single piece of good news, like the drop in unemployment claims, and make an unsafe, impulsive trade.

Watching Out for FOMO 🏃‍♀️💨

FOMO is a specific feeling that has received a lot of media attention in the past couple of years. The acronym stands for fear of missing out, and it’s a feeling of anxiety that sets when, for example, you think others are having fun without you. In the simplest of terms, it’s a fear of regret.

But we’re not dealing with FOMO in that sense today. FOMO occurs in trading as well – whenever we see a success story or a screenshot of someone’s incredible returns, we feel the natural urge to jump in. After all, who wouldn’t want to replicate those successes? 

However, that’s extremely irrational and can end up costing you money. The end result that we see with the success of others is enticing – but it’s only a partial picture. We don’t know what sort of risk they took on, how they came to the idea to invest in what they did, and how much of their success is due to skill and preparation, and how much is due to sheer chance.

If you’re chasing after others, you’re already late to the party. The fear of missing out leads traders to jump in at bad entry prices, and it causes traders to forget about proper risk management and analysis.

If you give in to FOMO, you’re not acting – you’re reacting. And if you’re reacting, the gains that were to be made from a particular stock or trading currency have already been made – it’s already too late to replicate the success of whoever you’re currently fixating on.

So, how do you deal with FOMO? Stick to the rules you’ve set in place for yourself – don’t make exceptions because of hype, don’t exceed your risk tolerance, and don’t go out of the bounds of your trading system.

Successful Trading Doesn’t Require Greed 😈

Greed is the other side of the same coin that contains fear. Although it functions in a different way, it is no less dangerous, and in fact, it might be even more dangerous.

We don’t usually consider greed to be a huge problem when it comes to trading – after all, we’re all in it for the money. But there’s a difference between a healthy, ambitious appetite for profit and an unreasonable approach that is based on emotions.

Greed is partially euphoric – when things are going well, we’d all like to believe they will stay that way forever. But that doesn’t happen – even the most impressive positive trends supported by fundamental analysis turn around sooner or later.

Trying to hold on to an investment until you can extract every single dollar out of it is foolish. At one point, all the potential gains that you could have realized will be erased, and you might even end up losing money.

Greed is a tricky emotion – it plays strongly to our natural tendencies as traders and investors. This is why it is one of the most insidious problems that market psychology deals with. Counteracting it requires an impressive level of self-discipline. 

It’s easy to get swept up in the overconfidence that ensues after a few good trades or an economic boom. Stay rational – don’t deviate from your strategies, and don’t forget to set and stick to profit targets.

Sure, sticking to profit targets will inevitably result in selling some of your investments before they hit their peak – but this will allow you to lock in steady, reliable profits, and it will save you from a lot of losses. This will also help keep you in a rational mindset and serves as good practice for resisting other emotional impulses as well.

Getting Aboard the Hype Train 🚂

Hype has always existed in one way or another – but with the advent of social media and the internet, it has taken on a completely different form.

Hype spreads like wildfire, and it can appear in an instant – making it impossible to predict. But when it does occur, it will invariably reach you – and you will inevitably feel the urge to hop on the hype train.

This feeling is in the intersection of greed and FOMO – you want to make the big returns that people have already made, and you don’t want to miss out on what looks like a once-in-a-lifetime opportunity.

And don’t get us wrong – as recent events regarding the Gamestop (GME) short squeeze have demonstrated, there’s money to be made from hype. But it should still be avoided – and there are good reasons why.

Hype is a fickle beast. It brings huge volatility to the table, but it is far too unpredictable, and the risks are far too great for most traders, although they usually don’t see this or simply don’t consider it as they get lost in the hype.

And success isn’t guaranteed with hype – there’s nothing to say that you aren’t already late to the party and that your investments won’t end up costing you money. At some point in time, the price that is wildly fluctuating will correct itself – and hoping that you’ll be rational enough to exit a position that you entered because of irrationality is a losing bet.

Beyond that, hype is unreliable. Even if you jump aboard the hype train on time, this won’t make you a successful trader. Only discipline, knowledge, and experience can allow you to get to a point where you’re making reliable, steady profits from trading – and that’s the mark of a pro.

Dangers of Hope ☀️ ⛈️

Hope is the first step on the road to disappointment. Of course, hope is a natural thing, and none of us can avoid hoping that we’ll achieve good profits – but this is one emotion that has to be carefully monitored and controlled.

While greed and fear are obviously dangerous, hope can seem like a positive, beneficial emotion. Don’t fall for it. When it comes to trading, there’s no such thing as a beneficial emotion – your goal should always be to act as rationally as humanly possible.

High hopes obscure your perspective of the real state of the markets. It can cause you to keep losing positions open for far too long, and can even make you place bad bets on account of unfounded optimism. 

Our desire to see something happen has a way of making us forget about much more concrete factors. This emotional reaction can give traders a false sense of confidence – and that’s the last thing that you need.

Keeping hope in check is a difficult task. None of us like to admit that we’ve made a mistake – but the false sense of security that hope can give you won’t pay your bills. Remember that hope isn’t an investment strategy.

Take DoorDash (DASH) for example – from February of 2021 to April, this promising delivery service’s stock price dropped from $215 to $143, and without showing any particularly strong signs of recovery. Hoping that the situation will turn around, without any rational reason to back that hope up, simply leads to disappointment.

Don’t get too attached to your investments, and never break the ground rules you’ve set for yourself. Hope won’t save you from losses – but a well-made and well-executed strategy that you always stick to will.

Noise and Confusion 🔊

Noise and confusion also play a role in trading psychology. And no, we’re not talking about your neighbor’s leaf blower and the sense of confusion you feel when he revs it up during working hours – we’re talking about information overload, a common occurrence in today’s real estate market as well as elsewhere.

The internet is chock-full of content relating to the stock market. We should know – our website is merely a single (albeit shining) example. The amount of information that can be gleaned and the knowledge that can be obtained via the internet is a blessing – most of the time.

However, that blessing can easily turn into a situation best described as too much of a good thing. The sheer scope of the information that is available to you makes it easy to lose focus.

Now, don’t get us wrong. You should keep an eye on the news, use the internet to educate yourself, and pay attention to what is going on – but keep things reasonable. 

If you’re subscribed to 10 newsletters, regularly follow 15 analysts on Youtube, and have 10 Reddit threads opened in your browser, you’re spreading yourself too thin.

It’s important to narrow down the input of information that you’re receiving to a manageable level. This means that you should take in as much information as you can – so long as you can properly analyze and assess what is in front of you.

Simply soaking up information isn’t enough – you have to process it in order to get something that is actually actionable and useful. You don’t have to learn about everything at once – trading is a lifelong pursuit, so you should take things at your own pace.

And remember – quality trumps quantity. A couple of reputable sources of information are worth far more than thousands of hours or pages of badly written, unfounded, vague content.

The Cycle of Investor Emotions 🎢

Although the emotions that you’ll experience during the course of your trading journey vary depending on what is happening with your portfolio, if we take a step back and take a look at a longer timeframe, things usually follow a pretty distinct pattern.

This is called the cycle of investor emotions. The market itself is subject to cycles — some of them bullish and optimistic, and others bearish and much less hopeful. These cycles repeat on and on — and they are reflected in the cycle of investor emotions.

Let’s take some time to cover each of these stages, though briefly.

Optimism 🔝

The initial stage of the cycle starts with high spirits — you’ve decided to invest, found a good opportunity, and are eager to see the results of your plans come to fruition.

Excitement 🔝

The second step begins when things start developing in your favor — as they should if you’ve done your homework. Due diligence begins paying off, and this is the beginning of a snowball effect — as your good mood will only improve with further returns.

Thrill 🔝

As the snowball effect of positive emotions continues, you will suddenly feel newfound confidence — you might think to yourself that you’re getting the hang of this, or that your system is foolproof.

Euphoria  🔝

Once the stage of euphoria is reached, any and all due diligence goes out the window — and so does your ability to properly estimate risk. At this point, most investors feel like not pumping more money into the market is just a waste of good opportunities. Although this stage reflects the stage of the market where potential gains are the greatest, at this point, you’ve also dropped your guard — and so the financial risk is at its highest point here as well

Anxiety 📉

As the positive trends in the market reverse, as they inevitably always do, you’re going to feel a certain amount of anxiety and doubt. However, most investors will adopt a “stiff upper lip” attitude, confident that these drops are merely temporary setbacks, and that in the long term, things will bounce back.

Denial 📉

As the market keeps dropping, your confidence will be shaken. Eventually, you will completely disregard anything to do with the long term, and focus solely on the short term, desperate for any improvement.

Fear 📉

As the downward trajectory of your investments continues, you will quickly find yourself disoriented and confused. At this point, all of your confidence has evaporated, and you might very well find yourself paralyzed with indecision. Although you could cut your losses or secure small profits, it is unlikely that you will end up doing so.

Desperation 📉

If like most, you haven’t pulled your investments, you will arrive at the point of desperation — when there is no chance at making a positive return.

Panic 📉

This is, by far, the most intense stage of the entire cycle. It is characterized by a sense of helplessness and feeling like you have no control over what will happen next.

Capitulation 📉

Once the last inch of hope has been squeezed out of you, you will most likely sell all of your investments or positions. You’re well aware that is far from ideal — but it will prevent you from accruing additional losses.

Despondency 📉

You’ve exited the market, and you’ve likely lost some money in the process. You probably won’t feel like investing or trading ever again — but this stage also markets the moment of maximum financial opportunity — provided that you’ve absorbed the lessons that are to be learned from this cycle.

Depression 📉

The emotional fallout from setbacks and losses is inevitable. This stage marks the “make it or break it” point in your journey as a trader — either you give up entirely, or go back to the drawing board and use the experience you’ve gained to find out where, when, and how you made mistakes.

Hope 📈

If you decide to stick with trading and become aware of both the cycles of the market and the cycle of investor emotions, you will eventually realize that things have gotten better and that conditions are favorable again. This is the prime moment to look for new trading ideas.

Relief 📈

As the markets start showing strong signs of recovery, you will feel relieved. Although wearier, you will regain faith in your ability to successfully trade — and soon after that, optimism will soon set in again, starting the cycle anew.

The Importance of Setting Rules 🔎

The whirlwind of emotions that you’ll run into while trading is complicated, difficult to understand, and it can never be fully explained using reason. However, the solution to the problems that those emotions pose is actually rather simple.

Just as you have to develop a trading strategy in order to know when to trade, you have to develop a system of rules for dealing with emotional turbulence when trading. We’ll go into more detail and deal with some of the specifics down below – for now, we’ll discuss the benefits of setting rules.

Unlike emotions, both positive and negative, rules are set in stone. They don’t sway and change with your mood or the performance of your portfolio. As such, they’re something that you can always fall back and rely on.

When it comes to emotions, reflection is key. Try to practice mindfulness – before you make any important decision, try to ascertain your emotional state and ask yourself whether or not you’re acting from a rational, level-headed place, or simply reacting to emotional stimuli.

But not all of your rules have to be so abstract – setting reasonable profit goals and making good use of advanced orders can take a lot of guesswork and uncertainty out of your trading process.

Of course, all of this requires a certain level of discipline – but with practice, you can achieve it. Sticking to a certain level of risk or only trading with a certain percentage of your portfolio each day will not only allow you to stay cool-headed – but will also spare you from both psychological and financial damage.

Trading Psychology Tips You Need to Know ⚡

Everything that we’ve covered so far has been pretty abstract. And that is simply the nature of the beast – we’re dealing with emotions and irrationality here.

But no knowledge, no matter how abstract, is worth a single penny if it cannot be digested into a list of actionable tips. We’ve singled out a couple of the most important ones down below – learn them by heart, and you will always have a solid foundation to fall back upon when things get tough.

1. Don’t Trade with What You Cannot Lose ⚠️

Unlike investing, trading happens in the short term and involves a much larger number of buys and sells. Inevitably, this means that a lot of your traders are going to incur losses. This is unavoidable, and it’s perfectly fine – so long as the wins outpace the losses, things are going well.

However, what we’ve just said only holds true if you practice proper risk management. That means trading with a predetermined amount of your portfolio every time. No risky trades, no big bets, no exceptions.

Proper risk management entails limiting yourself so that you don’t experience huge losses. This also eliminates the risk that you’ll wipe your account when you end up on a losing streak. It also pushes you toward a mindset that isn’t focused on acquiring large one-time gains – rather, it will steer you toward developing a strategy that works reliably in the long run.

Most professional day traders set a cap of 0.5% to 1.5% of their portfolio to be used for each trade. However, novices should perhaps take an even more cautious approach – the 1-percent risk rule limits you to using 1% of your portfolio for each and every trade.

Even stocks that seem like a safe bet can experience large, unexpected drops. Take Tesla (TSLA) for example – in September of 2020, its battery day announcement led to an unexpected and large drop in stock price – from $450 to $350. Note that this happened despite the good news they announced at their battery presentation.

Besides limiting losses, this will prevent you from stressing out too much over your trades. If a large proportion of your portfolio is tied up in a position, it’s more or less impossible to act rationally.

2. Average Gains Are What Matters 📊

People tend to get swept up in the moment – and even seasoned traders aren’t immune to this reaction. If you’ve strung together a decent streak of winning trades, naturally, you’re going to feel good about yourself, and you’re going to feel as if everything is going fine.

Conversely, if you’ve had a couple of bad days in a row, you might feel as if your portfolio is completely doomed. None of these sentiments, neither the positive one nor the negative one, however, is accurate.

The emotional effects that ensue when things go strongly in a particular direction – the high of a winning streak or the despair of a losing streak, both cause tunnel vision. They make you focus on the little picture because it is more recent and vivid, but that perception leaves out the big picture and doesn’t give you an accurate idea as to how you’re really doing.

Always focus on the big picture and on the long term. It doesn’t matter if you’ve had 100 successful trades in a row if you wipe out those gains at a later date – in the same vein, it doesn’t matter if you’ve had a bad week – so long as you recover from your losses.

If you want to get a good idea of how your portfolio is doing, look at monthly and yearly gains. So long as those are in order, you’re doing fine. In fact, even a couple of bad months can be excused if you’ve made a profit when looking at the entire year.

3. Take a Break If You Are Losing ⏳

Sooner or later, you’re going to hit a rough patch. It happens to everyone, even seasoned veterans that have many decades of experience under their belt. And no one can stay indifferent when things start going wrong – at some point, the stress of back-to-back losses will get to you.

We’ve already said that average gains, in the long run, are what matters – but after a weeklong losing streak, no one is going to be sane enough to remember that fact and think about the grand scheme of things. In that state, you’re just bound to make more mistakes – so what should you do?

Nothing – you shouldn’t do anything. You won’t be in the right frame of mind to make rational choices – so you shouldn’t make any. Take a break – the stress of a losing streak will wear anyone out. Be honest with yourself and take all the time you need – sometimes a couple of days will do the trick, but in other situations, a longer break might be warranted.

This accomplishes several things. First of all, it cuts further losses to 0%, so you’ve automatically stopped hemorrhaging money. It also allows you to take a step back, calm down, and find the time and energy to come up with rational, level-headed strategies that will help you earn consistent profits once you get back in the saddle.

Don’t let your bruised pride get in the way of making the right decision – you need time to regroup and rethink your approach. Once you’ve decided to take a break, don’t do it half-heartedly – don’t check prices, don’t read financial news, and don’t try to come up with new strategies at once. 

Once you’ve truly returned to a calm, rational mindset, then you can figure out what your next moves ought to be.

4. Don’t Share the Markets’ Sentiment 🚫

The market often acts in unpredictable ways. This is because the only thing that it truly reflects is the sentiments of millions of investors. And while that might be true, you don’t want to follow the herd and share the markets’ sentiment.

Put simply, that will always result in sub-par trades. Reenacting the moves of other investors is a surefire way of getting bad entry prices and getting in on the action far too late to make a profit that is worth the effort – that is if you profit at all.

We’re not recommending mindless contrarianism here, either – your actions should be based on stock research and financial metrics, and they should fit within the framework of a wider strategy that has been tested and backtested. The markets’ sentiment is a piece of the puzzle – it should figure into your decisions, but your decisions should not be based upon it.

Don’t take our word for it, though. Even Buffett said that investors ought to be “fearful when others are greedy, and greedy when others are fearful”—wise words that are very relevant in a volatile market. And this quote from the Oracle of Omaha illustrates a very simple but important point – following market sentiment will lead you to overpay for certain assets, and will prevent you from picking up good opportunities.

Most traders fail to make decent, reliable, long-term profits – so it stands to reason that acting as they do is a recipe for disaster. Following the markets’ sentiment is the farthest thing from actional rationally – if you do that, you’re not even acting – you’re reacting, and no one ever got rich by simply reacting.

5. Remember—the Markets Are Random 🔀

The stock market is a gargantuan institution, and it is impossible to fully grasp it and all of its complexities fully. We know a lot about how the market functions, and how investors tend to act in response to certain events and changes – but none of that is foolproof.

In truth, the only thing that the stock market truly reflects is mass psychology – the sentiments of millions of investors, institutional and individual alike. And as we’ve discussed, most investors, unfortunately, aren’t rational.

In accordance with this fact, the market doesn’t always act rationally. It is often chaotic and always difficult to predict. With today’s near-instantaneous communication, news travels quickly – and it can easily cause sudden and dramatic changes to the market.

Market Randomness Example 👇

To further illustrate this point, we’re going to use an example. And in a not-so-shocking twist, it involves Elon Musk and his Twitter account.

Back in January of 2021, a change in the privacy policy of Whatsapp caused a mini-exodus to other communication apps. Musk urged the public to use Signal, one of the many alternatives to Whatsapp – and this caused a lot of people to invest in Signal.

Except that they didn’t – instead of the communication app, investors poured money into Signal Advance, a component manufacturer that had been trading for just 60 cents and had been operating at a loss for years. The stock’s price rapidly rose to over $70 in a matter of days.

Although an extreme example, this story illustrates just how random the markets are capable of being. The price movements of Signal Advanced made people rich, of that there is no doubt – but there was no rational reason why the company’s stock should suddenly be so valuable. No chart, metric, or trading strategy could have predicted what happened.

What this means in practice is that even the most rational and well-thought-out strategies sometimes fail. There’s no silver bullet – sometimes you can do everything right and still end up losing.

Don’t forget this fact. It’s easy to get demoralized when you spend weeks analyzing fundamentals, doing technical analysis, and making a strategy only for it to fail due to some completely unforeseen and random factor.

The proof of the pudding is in the long-term performance of your strategies. Just because you did everything right and still failed doesn’t have to mean that your strategy isn’t good. Losses should always cause you to reconsider what you are doing – but don’t assume that they automatically mean that you should switch things up.

Always approach losses on a case-by-case basis. No strategy can account for sudden news or the actions of others – so when you do fail, ask yourself if you failed because your strategy wasn’t up to par, or in spite of the fact that your strategy was good.

Conclusion 🏁

If you’ve made it this far – congratulations! This guide deals with a lot of abstract concepts, but all of them have tangible consequences on your success as a trader. While this topic might not be as cut-and-dry as some of our other guides, it is no less important.

Now that you’ve become acquainted with trading psychology, the real work begins. Putting what you’ve learned here into practice requires a lot of introspection, discipline, and commitment, and it will require you to constantly think about your approach to trading as well as your emotional state when trading.

However, it’s worth the effort. The stakes are simply too high for you to approach trading in an irrational manner or act on the basis of emotion. 

And as you’ve reached the end of this guide, you’ve already demonstrated a commitment to doing things the right way – so as a treat, you can afford some emotion right now – a teeny tiny bit of pride – so long as you keep up with that commitment.

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